these firms. If, for instance, we find a company to be
undervalued because it trades at 15 times earnings and
comparablecompanies trade at 25 timesearnings,we may
stillloseontheinvestmentiftheentiresectorisovervalued.
In relativevaluation, allthat wecan claimis thata stock
lookscheaporexpensiverelativetothegroupwecomparedit
to; we do not make an absolute judgment about value.
Ultimately,relativevaluationjudgmentsdependonhowwell
wehavepickedthecomparablecompaniesandhowgooda
job the market has done in pricing them.
Contingent Claim Valuation
ThereislittleineitherDCForrelativevaluationthatcanbe
considerednew and revolutionary.In recentyears, though,
analysts have increasingly used option pricing models,
developedtovaluelistedoptions,tovalueassets,businesses,
andequitystakesinbusinesses.Theseapplicationsareoften
categorizedlooselyasrealoptions,butaswewillseelaterin
this book, they have to be used with caution.
Basis for Approach
Acontingentclaimoroptionisanassetthatpaysoffonly
under certaincontingencies—ifthevalueof theunderlying
assetexceedsaprespecifiedvalueforacalloption,orisless
thanaprespecifiedvaluefor aput option.Much workhas
beendoneinthepastfewdecadesindevelopingmodelsthat
valueoptions,andtheseoptionpricingmodelscanbeusedto
value any assets that have optionlike features.
Figure1.4illustratesthepayoffsoncallandputoptionsasa
functionofthevalueoftheunderlyingasset.Anoptioncan