Putting "Real Options" to Work

Investors can use the concept of "real options" to explain part of the difference in market value and the intrinsic value as calculated using traditional methods. Real options represent what is possible beyond the current business operations. Investors can ignore real options, try to find real option value for free, or consciously seek out companies that have abundant real option value.

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By Zeke Ashton (TMF Centaur)
January 30, 2001

What a difference a year makes. A year ago, "new economy" companies like Yahoo! (Nasdaq: YHOO) and Celera Genomics (NYSE:CRA) sported market caps of over $90 billion and $12 billion, respectively. At their lofty heights, the exceptional valuations given these companies last year were probably comprised in large part not by the forward projections of the current business, but by potential, or the "what if" factor. What if Celera uses its state-of-the-art knowledge and facilities for drug discovery instead of database services? What if Yahoo! launches a hot new product or service?  

Today, both companies sport valuations that are about 25% of where they were last year. Interestingly, neither company has stumbled dramatically in their business -- in both cases, the sharp cuts in valuation have come as a result of the market reassessing the potential of these two companies. 

The wild swings in value that a (supposedly) rational and fairly efficient market sometimes imposes on companies like Yahoo! and Celera are evidence that investors have difficulty evaluating businesses that hinge more on potential than the here-and-now. Is there some way for investors to get a better handle on how to value such companies?

The theory of real options
Let's start by taking a look at "real options," a concept that provides some interesting insight on how to value potential. 

The concept of real options was popularized by Michael J. Mauboussin, the chief U.S. investment strategist for Credit Suisse First Boston and an adjunct professor of finance at the Columbia School of Business. Mauboussin uses real options in part to explain the gap between how the stock market prices some businesses and the "intrinsic value" for those businesses as calculated by traditional financial analysis, specifically discounted cash flows.

Instinctively, we know that nobody can come up with a perfect "intrinsic value" number for a business. No matter how rigorous the analysis, the best one can come up with is a possible range of values and a probability. That's because putting a value on a business requires projecting future cash flows for the life of the business, and nobody can predict the future with perfect accuracy. Even if you take the most predictable, boring little business on the planet, there is always some probability that somebody at that company will do something unexpectedly brilliant or unbelievably stupid that will dramatically change the value of that business.

Need some real-world examples of companies exercising real options? Yahoo!'s decision to go into the Internet auction business as an extension of its portal services is one example. Ebay's (Nasdaq: EBAY) acquisitions of and Butterfield & Butterfield were exercises of real options, as was Coca-Cola's (NYSE: KO) recently announced move into flavored milk products. In each case, the companies involved made a strategic shift or added on to existing businesses in order to build incremental value.

In creating the concept of real options, Mauboussin is essentially acknowledging that companies are valued based on a combination of known business value plus a value that represents the opportunities for future value creation. To get some idea of how much "real option" value the market is assigning a given company at a given price, Mauboussin uses discounted cash flow to get a price for a company's existing business, and compares this to the market value. The larger the discrepancy between the market cap and the DCF value, the larger the value the market likely is assigning the real options available to the company.

Where real options live
Of course, real options are available to every company, though some companies have more options for value creation available to them than others. In his white paper on real options (available at, Mauboussin notes that real options should be considered especially when three factors are present.

The first factor is a smart management team that is constantly seeking to identify and exercise options to increase the value of the business. The second factor is a market-leading business. This is because market leaders tend to have access to more real options and the human and financial resources and operating scale to exploit them. Finally, and this one will seem counterintuitive at first, the more uncertain the market in which the company operates, the more valuable the options are likely to be. This becomes more understandable when you consider a company like Celera Genomics, which is positioned in an industry with immense but hard-to-evaluate potential. Nobody knows how big Celera's ideas could become, and therefore the option value must reflect at least some chance that the potential value could be huge.

It isn't a coincidence that these three factors all play heavily into the Rule Breaker investment strategy, which consciously seeks to invest in companies that are heavy on option value. Indeed, the principles of investing in companies that are first movers in emerging industries and that feature good management and smart backing can be translated into "looking for companies with LOTS of real option value." The first two factors are weighted heavily in the Rule Maker strategy, which hopes to benefit from the opportunities that come naturally to the leader in a given industry. 

How to use real options
Now that we've explored the theory of real options, let's talk about the application. It appears to me that investors have three choices when it comes to using real options:

1. Don't play the "real option" game.

The first choice is to ignore real options. If this is how you choose to play, you simply assess the company based upon the current businesses. This is the most conservative approach, and will probably ensure that you don't end up overpaying for a hyped-up company that is long on potential but short on revenues and earnings. Of course, you aren't as likely to find a 10-bagger or a 50-bagger in your portfolio, either.

2. Make sure you get the "real option" for free. 

The second choice is to consider real options, but only invest in companies that you consider to be selling for what the core business is worth. If you use this approach, you are basically looking to find companies with significant real option value that the market may be overlooking. Pay a fair price, get the real option value for free. 

3. Take your best guess at valuing the "real options."

The third and most aggressive approach is pure Rule Breaker. Actively look for companies that have the most real options. These will often be labeled as "overvalued" by the financial press. The financial press will often be right. By doing your best to assign some ballpark value to the option, you'll at least be forced to think about the valuation. Maybe you'll see huge opportunity that the market doesn't fully appreciate. If you're right, you might be rewarded with a 100-bagger like the Rule Breaker guys were with America Online (NYSE: AOL). If you're wrong, you might be rewarded with a year in which you lose half your money, like the Rule Breaker Portfolio did last year. Either way, if you decide to play the real option game, be prepared for some volatility -- and try to determine ahead of time how much heat you can stand. 

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