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1/ Thread: Valuation with Real Options
Today @mjmauboussin and Callahan published a short paper on how volatility and falling WACC has affected valuation in 2020.
Here are my key notes from the paper.
Today @mjmauboussin and Callahan published a short paper on how volatility and falling WACC has affected valuation in 2020.
Here are my key notes from the paper.
2/ What is "Real Options"?
It is a right, but not an obligation, to make an investment in a new line of business/distribution center/product expansion etc.
There are parallels to financial and real options.
Here's a classic example of Real Options for extractive industries.
It is a right, but not an obligation, to make an investment in a new line of business/distribution center/product expansion etc.
There are parallels to financial and real options.
Here's a classic example of Real Options for extractive industries.
3/Where do we look for real options?
Here's a short checklist:
1. Quality of management
2. Position of the business
3. Evolution of uncertainty.
For more clarity, see the image.
Here's a short checklist:
1. Quality of management
2. Position of the business
3. Evolution of uncertainty.
For more clarity, see the image.
4/ What's going on in 2020?
Valuing a company can have two parts: one assessing the normal operations and valuing it based on DCF or multiples, and the other assessing via real options lens.
Discount rate is of course a significant driver for equity valuations.
Valuing a company can have two parts: one assessing the normal operations and valuing it based on DCF or multiples, and the other assessing via real options lens.
Discount rate is of course a significant driver for equity valuations.
5/ UST 10-yr yield declined from 1.92% in Jan to 0.84% in Nov in 2020.
Moreover, implied equity risk premium has declined 70 bps to 4.5%.
Overall, cost of equity dropped to 6.1% in Nov 2020, which is a whopping ~180 bps below of the avg of 7.9% in 2015-2019.
Moreover, implied equity risk premium has declined 70 bps to 4.5%.
Overall, cost of equity dropped to 6.1% in Nov 2020, which is a whopping ~180 bps below of the avg of 7.9% in 2015-2019.
6/ Just look at VIX to CoE ratio.
Here's how volatility can affect options:
"A financial option with a stock price of $30, an exercise price of $40, a life of 2 years, and volatility of 33% is worth $2.65. The same option with a volatility of 46.5% has a value of $4.85."
Here's how volatility can affect options:
"A financial option with a stock price of $30, an exercise price of $40, a life of 2 years, and volatility of 33% is worth $2.65. The same option with a volatility of 46.5% has a value of $4.85."
7/ But can stock price volatility be good proxy for volatility of real assets?
The timing and strength of economic recovery, picking winners and losers of the pandemic, and evolution of business models indeed introduced significant volatility in real options as well.
The timing and strength of economic recovery, picking winners and losers of the pandemic, and evolution of business models indeed introduced significant volatility in real options as well.
8/ 2020 exhibited highest dispersion among stocks after 2009.
Bloomberg Barclays US Liquid Convertibles Bond Index is +44% in 2020, far higher than $SPY and bonds implying that the value of options has increased significantly.
Bloomberg Barclays US Liquid Convertibles Bond Index is +44% in 2020, far higher than $SPY and bonds implying that the value of options has increased significantly.
9/ So what to do about it?
Here's a simple 2 by 2 matrix framework to approach this problem.
Some of the biggest beneficiary in 2020 have been companies with rich real options.
Here's a simple 2 by 2 matrix framework to approach this problem.
Some of the biggest beneficiary in 2020 have been companies with rich real options.
End/ Link to the full piece: https://www.morganstanley.com/im/publication/insights/articles/articles_wacc_and_vol.pdf?1608592201523
All my twitter threads, including other Mauboussin papers: https://mbi-deepdives.com/twitter-threads/
All my twitter threads, including other Mauboussin papers: https://mbi-deepdives.com/twitter-threads/
