Stock Market Values (Part 4)

How do you value a company when there are no earnings?

Photo: Mary R Vogt. Source: Morguefile

Is it just a case of irrational exuberance? Not necessarily. Traditional discounted cash flow analysis is a useful tool when it comes to evaluating financial assets, but it has its limitations. One aspect of investing that DCF analysis ignores is management’s flexibility. They can delay bringing a product to market, or expand its production to meet an unexpected surge in demand, or shift how their facilities are used—perhaps to produce a different kind of product. This kind of flexibility has real value.

To capture this value, we use option-pricing methods to supplement traditional valuation. An option is an asset that can go up, but is limited to the down-side. If management possesses a patent on a new drug, that patent has value even though it’s not producing cash right now. The upside may be huge, while the downside is limited to the cost of bringing the medicine to the marketplace.

Call option pricing. Source: Wikipedia

This is also why many tech companies seem to persistently carry such high valuations. The market is putting a high value of their potential growth, and the flexibility management has to pursue different approaches to their business. Putting a value on this kind of asset—management flexibility—is difficult, but it can be done. It depends on the cost of exercising the flexibility, the potential upside a change could realize, the amount of time management has to make the decision, and how volatile conditions are. The more volatile things are, the more these options have value. These values can all be quantified in a pricing model.

Black-Scholes Option Pricing Formula. Source: Wikipedia

In practice, this involves a lot of assumptions about stock prices and strike prices and market volatility run through an analytical model with decision points and normal distributions. Additionally, the real world will insert complexities that our models can’t accommodate. Nevertheless, options methodology is essential for understanding why some money-losing companies still have high market values, and why some profitable companies seem so cheap. Today, it seems, the market is putting a lot of value on the options that internet-media companies like Amazon and Netflix possess.

It’s not necessarily irrational just because you don’t understand it. Sometimes, what is unseen is more important that what is seen. It’s all in the options.

Douglas R. Tengdin, CFA

Chief Investment Officer

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