Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

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specifiedlevel.Therearemanyassetsthatgenerallyarenot
viewed as options but still share option characteristics. A
patentcanbeanalyzedasacalloptiononaproduct,withthe
investmentoutlayneededtogettheprojectgoingconsidered
thestrikepriceandthepatentlifebecomingthelifeofthe
option.Anundevelopedoilreserveorgoldmineprovidesits
ownerwithacalloptiontodevelopthereserveormine,ifoil
or gold prices increase.


TheessenceoftherealoptionsargumentisthatDCFmodels
understatethevalueofassetswithoptioncharacteristics.The
understatement occurs because DCF models value assets
based on a set of expected cash flows and do not fully
considerthepossibility thatfirms canlearnfrom real-time
developmentsandrespondtothatlearning.Forexample,an
oilcompanycanobservewhattheoilpriceiseachyearand
adjust its development of new reserves and production in
existing reserves accordingly rather than be locked into a
fixedproduction schedule. As a result,there shouldbe an
optionpremiumaddedontotheDCFvalueoftheoilreserves.
Itisthispremiumonvaluethatmakesrealoptionssoalluring
and so potentially dangerous.


Applicability and Limitations


Using option pricing models in valuation does have its
advantages.First,therearesomeassetsthatcannotbevalued
with conventional valuation models because their value
derivesalmostentirelyfromtheiroptioncharacteristics.For
example,abiotechnologyfirmwithasinglepromisingpatent
fora blockbustercancerdrugwending itswaythrough the
Food and Drug Administration (FDA) approval process
cannot be easily valued using DCF or relative valuation

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