Real Options: The Haves & Have Nots

All companies have real options, but some have more than others. In this article, two Fools debate the expanding possibilities for some of today's most intriguing companies.

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By Zeke Ashton (TMF Centaur) and Bill Mann (TMF Otter)
February 6, 2001

In my last Fool's Den article, I introduced the concept of "real options," and how investors can put them to use. As a quick review, "real options" represent the future value that companies could create by exploiting opportunities to grow the business. And the more uncertain and potentially rewarding the business, the more those options might be worth. As you might have noticed, real options can quickly turn into rationalizations for a company's sky-high valuation, but real-option theory also has its Foolish uses.

Today, I'd like to explore the applications of real options by looking at some real-world companies. My friend Bill Mann will shout out companies, and I'll respond with my thoughts on the real option value of that company. Ready, Bill?


Zeke: Uh, Bill? 

Bill:  Oh, sorry. I thought you were never going to finish talking. Ok, how about Internet Capital Group (Nasdaq: ICGE)?

Zeke: Great example, Bill. 

Bill: What, no good?

Zeke:  Sure. It's a great example of how not to use real options in making investments. I'd suggest that Internet Capital was a stock story, not a business one. Internet Capital turned its investments in dozens of B2B e-commerce start-ups into an enormous market cap in 1999. Essentially, the market was assigning a large probability that ICG would become the Internet version of General Electric (NYSE: GE).

Bill:  At a minimum, it's too early to say for them. While we can't count ICG out yet, it's clear that the option value assigned to all of its investments is not nearly what the market projected it to be a year ago.

I love the fact that they put money into eMerge, though. Five years ago, if I were to come to you and say that I wanted to provide an Internet cattle platform, what would you have said?

Zeke: I'm not sure, but I'm sure Mad Cow Disease would have figured heavily.

Bill: Who's to say it didn't? Okay, what about (Nasdaq: AMZN)?

Zeke:  In my view, has been a very appropriate company for which to use real options. It's a company that, at least back when the old Fool Portfolio (now the Rule Breaker Portfolio) bought it, was generally viewed as simply a newfangled company using the Internet to get into a business (bookselling) that wasn't all that attractive to begin with. Well, the reality was that there were a lot of options available to Amazon that the market didn't factor in. But that was before became a household name, before the huge explosion of dot-com stock valuations, before Jeff Bezos was named Time's man of the year. As often happens, the market went overboard after that and assigned the company a value that looks a little silly in retrospect. Now that the company has clearly defined some of its limitations, our Rule Breaker guys are discussing whether or not to sell their shares. (See related links below for more on this.)

Their discussion is centered primarily on the question of how much potential Amazon has left. But clearly, the market is starting to price Amazon based upon its current businesses, and there is essentially very little real-option premium left at current prices, in my opinion. That doesn't mean that Amazon is underpriced, it just means that the market no longer assigns a large amount of value for whatever Amazon might do in the future. 

Bill: What about Yahoo! (Nasdaq: YHOO)?

Zeke:  I think Yahoo! is in a similar boat to Amazon, in that the company valuation at one point was largely based upon potential. Now I think the market is valuing Yahoo! largely based on its current businesses, although a modest premium is probably still there. I think Yahoo! still has a lot of potential to create value beyond its current operations, and it has as much option value as any company I can think of. That's why we are still holding our shares in the Rule Maker Portfolio, and why I am holding tight to my own shares as well.

Some other companies that I consider to have exceptional option value are Nokia (NYSE: NOK), Enron (NYSE: ENE), and Celera Genomics (NYSE: CRA). Nokia's options just kind of get lost in a company with annualized sales of more than $30 billion. Celera is an interesting proposition right now, and if the market continues to punish the shares of companies without earnings, some of them might fall to a point where there is considerable option value at very low prices. If it happens to Celera, I might be taking another look at that company.

Bill: Geez, Zeke, if you can name all of the companies yourself, what do you need me for?

Zeke: Oh, sorry.

Bill:  I'm just saying that someone seems to like to hear himself talk, that's all. Here's one -- Berkshire Hathaway (NYSE: BRK.B).

Zeke: That's an interesting choice. I would have to say that Berkshire Hathaway has the most undervalued real options of just about any company I can name. If you look at the amazing history of this company, it started out as just a cigar-butt investment in a textile company, a company with one little puff of value left in it. In 1967, Warren Buffett decided to use the cash flow from the textile operations to buy a small insurance company, National Indemnity. Since then, Berkshire has entered the confection business with its 1972 purchase of See's Candies, bought a newspaper, become one the largest retailers of both furniture and jewelry in the U.S., and entered the aviation business with purchases of FlightSafety and Executive Jet. And the company is now one of the largest insurance companies in the world. In year 2000 alone, Berkshire has purchased four different companies in the building-products business. In short, this is a company that has basically taught a 30-year lesson on how to properly exercise option value. Warren Buffett might not call it that; he'd probably refer to it simply as proper capital allocation. What's interesting is that the market doesn't assign Berkshire Hathaway stock much of a premium for this exceptional track record. I would be hard-pressed to name a company that deserves more of a real-option premium than Berkshire Hathaway. 

Bill: Well, except for Church & Dwight (NYSE: CHD).

Zeke: Naturally -- wait, who?

Bill: Church & Dwight, the makers of Arm & Hammer baking soda. It's a company that was centered around a single product and an iron-clad brand for more than 150 years. It has a big commercial division, but on the consumer side it was all Arm & Hammer all the time.

Zeke: All I know about Arm & Hammer is that you can make about a million different home remedies with it....

Bill: Exactly. That's the true definition of option value. Church & Dwight made the basic product, and people everywhere were adding their own value. So Church & Dwight parlayed their product's perceived versatility into real revenues by releasing dozens of other Arm & Hammer products, all based on the baking soda. They've got gum, kitty litter, deodorant, toothpaste, detergent -- shoot, they even went out and bought Brillo scouring pads and added Arm & Hammer baking soda to 'em. That's option value, my friend.

Zeke: Well, that's a good example. What have these products meant to Church & Dwight's value as a company?

Bill: Can't just take my word, can you? Okay, I spoke to Zvi Eiref, CFO of the company, who explained that the book value per share has expanded by more than 400% in the last 20 years, from $1.10 in 1979 to $5.84 in 1999. That may not seem huge, but we're talking about a company that sells a consumer staple and has paid increasing dividends every year. Church & Dwight took a basic product with a solid brand and turned it into something that your kitty, your refrigerator, your teeth, and your neighbors can't live without.

Zeke: Bill, I don't have a cat.

Bill: Note to self: Zeke needs a cat.

Bill Mann needs a nap. At the time of publication, he had positions in Berkshire Hathaway and Church & Dwight. For a view of all of Bill's positions, click here.

Zeke Ashton needs a cat and a nap, or maybe just a catnap. At the time of publication, he owned shares of Yahoo! and Berkshire Hathaway. To view Zeke's holdings, click here.The Motley Fool is investors writing for investors.

Related Links:
Putting Real Options to Work
Amazon's Limited Potential
Should We Sell Amazon?