Furthermore, valuation of natural resources companies also pose similar challenges. What if? Traditional valuation methods e. In the case of the natural resources company if its exploration is successful, then substantial profits will be generated and the company will be quite valuable; if not, again, it will be not so valuable; probably not even viable.
And if it sounds like that, then it may make sense to use option pricing theory to value such companies!
Equity is a residual claim Before embarking on the use of options in equity valuation, it would be useful to remind ourselves of some basic principles regarding what equity is. The equity of a company is a residual claim on the cash option method in business valuation of the company or the assets of the company in case of liquidation ; this means that equity holders can claim cash flows or assets after all other stakeholders e. However, there is another important point here that has to do with the principle of limited liability.
Metrics details Abstract The valuation of a company is difficult, even for companies which evolve in a well-known, mature industry. The problem is far more complex, when the firm is a new born start-up company, where the traditional methods based on future free cash flows are difficult to apply, given the difficulties of estimating the future cash flows. In addition, with the start up companies, we are confronted with a total lack of appropriate benchmarks. This is true for the internet companies where there is no universally acceptable method in financial theory.
This indicates that the maximum amount that equity holders may lose if the company was to become bankrupt cannot exceed the amount of their investment. As might be apparent by now, to apply the above formulas to value the equity of a company, we need to substitute the current price of the asset S with the current total value of the company V and the strike price K with the face value of the debt of the company D.
We are interested in calculating the value of the equity of the company let this value be E. Clearly, the company is now in distress!
What happens to the value of equity? Why is that?
This point would be of paramount importance for an external investor, for example a private equity company specialising in distress situations, who would be interested to know how much this company is worth. Let us now consider what has happened to the debt of the company and also the market-implied interest rate.
Susan Ward Updated March 14, A business valuation is a way to determine the economic value of a company, which could be useful in several situations. For example: You may need to sell the business due to retirement, health, divorce, or for family reasons. You may need debt or equity financing for expansion or due to cash flow problems, in which case potential investors will want to see that the business has sufficient worth. You may be adding shareholders or one or more shareholders may ask for a buyout. In this case, the share value will need to be determined.
Simply because the riskiness of the company has increased and therefore, its lenders require a much higher interest rate to compensate them for undertaking higher risk. Again, we demonstrate this through an example. Let us re-run our model and see what happens.
The reason for this is of course the increase in volatility of the total value of the company through the acceptance of the new project.
A better understanding of the behaviour of companies This short article has tried to demonstrate how we can use option pricing theory to value the equity of a company. However, apparent from our examples is that by building flexibility in an equity valuation model we can probably better understand complicated valuation situations and obtain insights regarding the behaviour of companies regarding selection of projects and capital correct strategy in options decisions.