Session 21: The Essence of Real Options

Lay the foundations for viewing and valuing some assets as options and how it adds to their values.

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there's very little evaluation that I
think of
as new different a sophisticated much of
what we do has always been done this
session is an exception i want to talk
about the application of option pricing
models in valuation not the value
options that's been around awhile but
the value real businesses
what kind of businesses could be an oil
company with undeveloped reserves a
young biotechnology company equity in a
deeply troubled company company losing
money with a lot of death the session i
hope the flesh shop why I think of
investments in these businesses as
options and what the implications are
for investors so now that we've talked
about introducing and relative valuation
it's time to turn our attention to the
third and final approach doing valuation
real options as i noted the very start
of the class this is perhaps the only
area valuation where we cannot draw new
and different things
quasi sophisticated models to do
evaluation but in this session ID like
to cut to the core and talk about the
intuition that drives real option
valuation when you do a discounted cash
flow valuation you take the expected
cash flows new discount them back to
come up with a value for the acid right
well for most assets that is an
appropriate measure of value but you
could argue that in some cases you're
gonna underestimate the value of an
asset especially when there are the
following options embedded in the acid
the first is the option to delay and
investment that looks bad today might
become good tomorrow and having the
proprietary rights to the investment can
still be valuable
the second is you have the option to
expect you can infer have an investment
that does not look good day too good
today in terms of cash flows but it
might give you a chance to enter new
market will create a new product that is
incredibly valuable that is the option
to expect and the third is the option to
abandon its some investments you might
get the right or the option to walk away
from that investment of things don't go
well that is the option to abandon
generically speaking we're saying that
if you have an acid with these options
embedded in them
traditional discounted cash flow
valuation is going to understate the
value
these acids in fact when use option
pricing and value businesses you're
arguing for attaching a premium to
traditional discounted cash flow
evaluations so it's good to be club
option pricing valuation is not an
alternative to discounted cash flow
valuation it's an augmentation you first
have to do a discounted cash flow
valuation before you embark an option
pricing to give you an idea of where the
value of an option comes from let me
give you a very simple illustration lets
him have an investment but there's a
fifty percent chance you could make a
hundred million and fifty percent chance
you could lose a hundred and twenty
million the expected value of this
investment is negative right you will
not take this investment now let's say I
took the same investment and broke it
down into two steps in the initial step
you take it into smaller increment so
that first step you get one or two
outcomes either the investment comes
back as a good investment which case you
make +1 email you it comes back as a bad
investment which case you lose 20
million if you lose the 20 minute to
stop the investment right away but if
you make the 20 million you continue and
if you win you make another 80 million
giving your total upside of a hundred
million and if you lose you lose another
hundred million giving your total
downside of a hundred and twenty million
if you look at the probabilities this
investment is actually equivalent to the
first investment
there's a fifty percent chance that you
make a hundred million and there's a
fifty percent chance cumulatively that
you lose a hundred and twenty minute but
here's the magical options if you take
the expected value of this investment
you're actually I would end up with a
positive expected value a bad investment
became a good investment when you took
it in two steps now step back and think
about why the second investment was
valuable and the first investment was
not the first aspect that made the
second investment valuable is you got
that first try
you were able to observe what happened
that first drive learn from it and
adaptive behavior think those are the
two key words that drive the value of
real options
it's learning and adaptive behavior let
me start being abstract and give you a
real world example
let's suppose you have to value oil
company in a traditional discounted cash
flow model here's what you do you take
the expected number of barrels of oil
that we produced each year you x
unexpected oil price you come up with an
expected cash flow and you discount back
at a risk-adjusted rain
what are you missing when you do that if
you write actually ran an oil company
you would not produce the same number of
barrels of oil every year and here's why
you get to observe the oil price first
right of oil prices are high you might
produce a lot of oil of all prices are
low you might cut back on production you
have the option to adjust production
there is learning from looking at the
oil price and adaptive behavior because
it changed the production that you have
based on that price that's what you're
looking for and drill options is this
their capacity to learn and can i change
my behavior to make a business or acid
more valuable
so here are the three basic questions
that I'd like to answer when i think
about applying option pricing to value
businesses first when is there an option
in a decision when should I even be
talking about option pricing let's start
with that question second question when
does that option of significant economic
value and this is where you're going to
see a drop off in the number of options
that you can actually value most options
that you see out there have either no
value are so little value that it's not
worth doing this so when does that
option of significant economic value and
the third and final question is when can
i use an option pricing model those
models that have been developed over the
last 40 years to value that option so
let's start with the first question when
is there an option embedded in action
when should i be using option pricing
there are three specific characteristics
that i look for to identify something as
an option first options are derivative
securities they derive their value from
something else so there's got to be an
underlying asset second options of
contingent payoffs something has to
happen for your cash flow to pay off and
third options of limited lives and
underlying acid a contingent payoff and
limited lives like the best way to
recognize when you're dealing with an
option is to draw the payoff
diagram for your cash flows and if your
payoff diagram looks like an option
payoff diagram you have an option on
your hands so very light very quickly
let's review the to type of option
payoff diagrams you can face if you have
a call option you get the right to buy
an acid a fixed price
here's what a payoff diagram will look
like there's a kink at the strike price
and if your value of the ice it exceeds
that strike price $MONEY
dollar-for-dollar you make profits but
the value of the asset falls below the
strike press you don't lose an unlimited
amount you lose what you paid for the
option to have limited losses below the
strike price potentially unlimited
profits above this above the strike
price if you have a put option it's like
holding a mirror up to those same cash
flows if the value falls below the
strike price now you lose money not an
unlimited amount because the price might
not be able to drop below zero but if
the value exceeds a strike price you
lose what you paid for the foot so
here's how i use payoff diagrams and the
sessions following you're going to see
this happen whenever I talk about a real
option i'm going to first draw the
payoff diagram to see if in fact i have
a call or a put option on my hands and
once i do that i'm on my way to using
option pricing second question you need
to ask when is that significant economic
value to this option let me give you the
key word that I think drives the
discussion of real options its
exclusivity if you and only you can
exercise this option
this option is significant value the
less exclusivity you have the less value
there is the option again this might
sound mysterious but let me give you a
very quick anecdote to bring this home a
few years ago secondary mba came into my
office and he was very excited his
landlord given him he said an option to
buy the apartment he was renting and he
wanted to use an option pricing model
value the option i said ok what price
did he say you could buy this apartment
the mba student talked for a while and
he said you know what he never mentioned
a price so I said let's get this
straight
your landlords told you can buy the
apartment renting right now any time
over the next year or whatever the
prevailing market price is right
he said hey get I guess that's what I've
got so what do you think that's what
anybody can buy the department at that
market price you have no exclusivity you
have no option value so with every real
option this is a question would stop and
ask is their exclusivity and it's not a
01 proposition you have total
exclusivity the total value the optional
come if it and absolutely no exclusivity
there is no option value if you're
somewhere in the middle you get part of
the value of the option now once you
decide your option is exclusivity then
we know what the determinant of option
value are and they're only 63 relate to
the underlying asset one is the value of
the underlying I says that moves up and
down the value of your option will
change the second is the variance in
that value as that variance goes up your
options will become more valuable and
this is where asset pricing gets turned
on its head because up until now
whenever we've talked about risk will be
buried here as risk goes up value goes
down in a discounted cash flow model as
risk goes up multiples go down a
relative valuation but an option pricing
model as risk goes up value goes up and
the reason is simple
you're protected on the downside
remember those payoff diagrams you
cannot lose more than what you paid for
the option so variance and risk becomes
your ally and the third and final
characteristic relating to the
underlying asset that matters is if that
is the pace of David it can affect the
value of your acid if you have a call
option on a stock or an ass that pays a
dividend on the day the dividends paid
the value of the asset is going to drop
which is going to make call options less
valuable and put options more valuable
there are two variables relating to the
option that matter what is the exercise
price itself as that changes the value
of the option to change the right to buy
something at a fixed price becomes more
valuable at a lower fixed price and the
other is the life of the option to more
time I give you to play the option the
more valuable it becomes there's only
one macro variable then enter the option
pricing model and that's the level of
interest rates and it matters for a
simple reason when interest rates are
high the present value what I have to
pay the future remember the price is
fixed becomes lower so call options
become more valuable
at higher interest rates and put options
become less valuable so once you have an
option and you decided that option has
significant economic value we know the
variables that drive the value of the
option so let's assume you found an
option you've decided to significant
economic value the next question final
question faces can i use an option
pricing model to value this option and
your we would understand the basics of
option pricing models i won't bore you
with the details but here are the two
basic principles that govern how we use
option pricing model what drives option
pricing models
the first is the principle of
replication what is replication you can
replicate or you can create a portfolio
over the underlying asset neither boring
lending that is exactly the same cash
flows as the option and once you do that
the second principle comes into play
which is arbitrage if the option in the
replicating portfolio have exactly the
same cash flows they have to trade at
the same price so all option pricing
models are built on replication
arbitrage but step back to be able to do
replication arbitrage hear the things
you have to be able to do you have to be
able to buy and sell the underlying
asset you have to be able to buy and
sell the option you have to be able to
borrow and let the risk-free rate now
it's difficult to meet all three
conditions but the further away you get
from those three conditions the less
likely it is that option pricing models
will deliver a fair estimate of value
for your option now with that setup let
me lay out the two basic option pricing
model they might run into in practice
the first of course is the black-scholes
morning the model that invented option
pricing as we know it in the
black-scholes model make restrictive
assumptions about a number of variables
for instance we assume that options are
European options what European options
European options can be exercised only
an expiration we assume that the
variance of the underlying asset remains
fixed over the life of the option and
finally we assume that the prices of the
underlying acid don't have any jumps to
they continue as they move in small
increments the big assumptions but if
you make those assumptions you end up
with a very simple model simple in terms
of the inputs uni in the option pricing
model
at lisa's seen by black and Scholes only
6 inputs and drive the value of an
option
the value of the underlying acid the
strike price the life of the option the
riskless rate the time to expiration and
the variance in the value of the
underlying asset that's it
there are no external variables so those
variables you can value any option but
it does basic on restrictive assumptions
the alternative is the binomial model in
the binomial model you're less
restrictive near assumptions you can
have early exercise you can even have
variances changing over time but here's
the catch a binomial model requires you
to be able to specify the prices at
every branch of the binomial model lot
more information needed to use the
binomial model now if you look at real
options and especially thrilled options
books many of them emphasize the fact
that the black-scholes model is
ill-suited to value most real options
the right-most real options have
changing variances overtime and require
only exercise but having agreed on those
stubs i still think that using the
binomial model is not an easy choice all
of the information you need for the
binomial will often lead you into a debt
and if you can estimate the entire
binomial model i would argue that this
is a far simpler way using decision
trees and basic statistics that you can
value any action so let me put it this
way if you have the information to draw
the entire binomial model you don't need
option pricing to value and acid if you
don't have that information you're going
to be stuck with the black-scholes
notwithstanding its limitations
so let me sum up options are useful to
to have but to apply the evaluation
there are three basic test you got to
meet first you got to make sure that
there is an option better than action
check for that second check to see if
you have exclusivity if you have
exclusivity of significant option value
and third check to see if you can trade
in the underlying asset and the option
because only then can the option pricing
models deliver an accurate estimate of
value as we see for every hundred option
to run out there may be two or three
will pass these tests but when they do
it's an interesting way in a useful way
to estimate value