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Chapter 11. Real Options in Valuation

Chapter 11. Real Options in Valuation

In discounted cash flow valuation, the value of a firm is the present value of the expected cash flows from the assets of the firm. In recent years, this framework has come under some fire for failing to consider the options that are embedded in many firms. For instance, the discounted cash flow value of a young startup firm in a very large market may not reflect the possibility, small though it might be, that this firm may break out of the pack and become the next Microsoft or Cisco. Similarly, a firm with a patent or a license on a product may be undervalued with a discounted cash flow model because the expected cash flows do not consider the possibility that the patent could allow the firm to enter new markets.

In both the examples cited above, discounted cash flow valuation understates the value of the firm, not because the expected cash flows are too low—they reflect the probability of success—but because they ignore the options that these firms have to invest more in the future and take advantage of unexpected success in their businesses. These options are often called real options because the underlying assets are real investments, and they might explain, at least in some cases, why discounted cash flow valuations understate the value of technology firms.


  

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