Online Tutorial #10: How Do You Assess The Value of A Company's Real Options?

The discounted cash flow model is all you need to estimate the expectations for most businesses. For companies with a high degree of 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. 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 take advantage of opportunities in the future. We can value opportunities with real options techniques.

In this online tutorial, we show how to apply real options valuation techniques to increase the power of expectations investing. Specifically, we walk through the following real options analytical tools:

Imputed real options value. This tool allows us to calculate the real options value implied by the difference between the market's valuation of a company and the value of a company's existing businesses.

Project value and investment expenditure. We can estimate how large the potential project value has to be to justify the imputed real-options value. We can also estimate the size of the investment expenditure required to exercise the real options.

We use the case of Shopify, Inc., as of September, 2020, which is developed in Chapter 8 of the book as the guide for this online tutorial.

Readers who want to apply real options tools may wish to download the accompanying spreadsheet.

What Inputs Do We Need For These Calculations?

To get started, we need to enter the following eight inputs into the spreadsheet:

1. Company name. Our case study focuses on Shopify. Enter this in cell C4 of the "Inputs" worksheet of the "Real Options" spreadsheet.

2. Current share price. Shopify's share price as of September 21, 2020 equaled $900.00. Enter this in cell C5 of the "Inputs" worksheet of the "Real Options" spreadsheet.

3. Estimated value of existing businesses. By estimating Shopify's operating value drivers and other value determinants, our case study estimates that the market valued Shopify's existing businesses at $800.00 a share. Enter this in cell C6 of the "Inputs" worksheet of the "Real Options" spreadsheet.

4. Shares outstanding (in millions). Shopify had 113 million shares outstanding. Enter this in cell C7 of the "Inputs" worksheet of the "Real Options" spreadsheet.

5. Life of option (in years). The life of a real option is the length of time that a company can defer an investment decision without losing an opportunity. As of September, 2020, we estimated that Shopify's real options had a life of 3 years. Enter this in cell C8 of the "Inputs" worksheet of the "Real Options" spreadsheet.

6. Risk-free rate of return (%). This is the interest rate on short-term government debt. We assumed a risk-free rate at 0.15%. Enter this in cell C9 of the "Inputs" worksheet of the "Real Options" spreadsheet.

7. Project volatility (%). This measures the potential variability of a project's future value. We estimated Shopify's volatility to be 50%. Enter this in cell C10 of the "Inputs" worksheet of the "Real Options" spreadsheet.

8. Estimate of potential project value [S/X] (%). The numerator of this metric (S) equals the present value of the project's expected free cash flow. The denominator of this metric (X) equals the onetime incremental investment required to exercise the option at the time of exercise. Various potential project values (S/X) equate to different scenarios for the profitability of the project created if and when a company exercises its real option to enter a new business:

S/X equals one. In this scenario, the net present value (NPV) of the project at the time of decision is zero.
S/X less than one. In this scenario, the NPV of the project at the time of decision is negative.
S/X greater than one. In this scenario, the NPV of the project at the time of decision is positive.

In our case study, we assumed the S/X of Shopify's real option equaled 75%. Enter this in cell C11 of the "Inputs" worksheet of the "Real Options" spreadsheet.

Using These Inputs To Perform Real-Options Analyses

Using these inputs, we first estimate the market's imputed real-options value by calculating the difference between the market's total valuation of a company, and the value of a company's existing businesses:

Next, we calculate the potential value of the project when the company exercises the real option (S), and the size of the investment expenditure necessary to exercise the real option (X). Using the Black-Scholes options pricing model, we obtain the following results:

The last step in real options analyses is to assess the reasonableness of the numerical results for S and X. This topic is covered on page 147 in Chapter 8 of the book.