As aninvestor,wecanuse bothdiscountedcash flowand
relativevaluationtovalueacompany.Optimally,wewould
like to buy companies that are undervalued using both
approaches. Thatway, we benefit from market corrections
both across time (which is the way you make money in
discountedcashflowvaluation)andacrosscompanies(which
is the path to success in relative valuation).
WHEN SHOULD WE USE THE OPTION PRICING
MODELS?
In Chapter12, wepresented a numberof scenarioswhere
optionpricingmayyieldapremiumontraditionaldiscounted
cash flow valuation. We do not intend to revisit those
scenarios,butofferthefollowinggeneralpropositionsthatwe
should keep in mind when using option pricing models.
- Useoptionssparingly.Restrictyouruseofoptionsto
wheretheymakethebiggestdifferenceinvaluation.
Ingeneral,optionswillaffectvaluemostatsmaller
firmsthatderivethebulkoftheirvaluefromassets
thatresembleoptions.Therefore, valuingpatentsas
optionstoestimatefirmvaluemakesmoresensefora
smallbiotechnologyfirmthanitdoesforadruggiant
like Merck. While Merck may have dozens of
patents,itderivesmuchofitsvaluefromaportfolio
of developed drugs and the cash flows they generate. - Opportunitiesarenotalwaysoptions.Weshouldbe
careful not to mistake opportunities for options.
Analystsoftenseeafirmwithgrowthpotentialand
assumethattheremustbevaluableoptionsembedded
in the firm. For opportunities to become valuable
options,weneedsomedegreeofexclusivityforthe