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Excerpts from the Book > Chapter 8

Chapter 8 : Beyond Discounted Cash Flow

Excerpt from Chapter 8

As you step through the expectations investing process, you will run across companies with price-implied expectations that are vastly more optimistic than what industry norms lead you to expect, as well as what existing businesses can ever deliver. In these cases, automatically concluding that expectations are too optimistic would be a mistake. For companies fraught with uncertainty, the stock price is the sum of discounted cash flow value (representing the existing businesses) plus real options value. Real options capture the value of uncertain growth opportunities. In this chapter, we show you how to use some straightforward real options valuation techniques to increase the power of expectations investing. We also introduce the notion of reflexivity, that is, how stock prices can affect business fundamentals.

Questions Addressed in Chapter 8

To explore the implications of real options, Chapter 8 answers the following questions:

  • What is a real option?
  • When does the discounted cash flow model understate the value of a business?
  • How can real options analysis help us understand start-ups and reinventors?
  • How can we use real options to value the option to expand, extend, or abandon a project?
  • What is the analogy between a real option and a financial call option?
  • What are the five inputs for any option value calculator?
  • What are some reasonable ways to estimate these inputs?
  • How can we use a lookup table to understand the relationship between the value of a real option relative to the size of the opportunity?
  • When should we use real options analysis in expectations investing?
  • How can we calculate market-imputed real options value?
  • What does the assumption underlying real options valuations—that cash will be available to fund the exercise of a real option—mean in practice?
  • What is reflexivity, and how can it affect real options values?
  • How does reflexivity affect financing growth and the ability to retain key employees?

Essential Ideas in Chapter 8

  • The discounted cash flow model can understate the value of flexibility, which can lead to a misreading of price-implied expectations for uncertainty-laden start-ups and reinventors.
  • Real options capture the potential value of uncertain future opportunities.
  • To determine whether or not you need real options analysis, consider both a company’s potential and market-imputed real options value.
  • You should incorporate the dynamic feedback loop from fundamentals to stock and from stock price to fundamentals—reflexivity—into the expectations investing process.

 

Chapter Errata

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