How do Option Pricing Techniques Differ from Traditional Valuation Methods?
In this article we will explore the advantages of each approach and when a certain methodology is more appropriate.
When Fischer Black and Myron Scholes introduced the Black-Scholes option pricing model in 1973, they completely transformed how we priced complex securities. While options had existed for centuries, this was the first time we had a reliable way to incorporate interest rates, volatility,, tenures of the options, and the price of the asset into the option price.
This monumental achievement earned Scholes the Nobel Memorial Prize in Economic Sciences in 1997. Scholes shared his Nobel Prize with Robert C. Merton, whose modifications to the Black-Scholes model ensured that it could be applied to other areas of finance. Black, unfortunately, missed out since the Nobel Prize cannot be awarded posthumously.
While the Black-Scholes model simplifies valuing complex securities, we cannot ignore the intuitive value of traditional valuation methods such as the discounted cash flow (DCF) method, comparable company method, book value method, and market-based method.
Hence, in this article, we will explore the advantages of each approach and when a certain methodology is more appropriate. Read on to know more!
What can we learn from traditional valuation methods?
The traditional methods follow either the income, asset, or market approach to valuation. Let us go over each of these approaches to understand how exactly they try to uncover the value of a business.
Income-based approach
In the income-based approach, we estimate a company’s future cash flows based on its financial history and expected industry and economic conditions. Once we have estimated the future cash flows, the next step is to discount them to find their present value using an appropriate discount rate.
When we discount future cash flows, we are accounting for the time value of money and the risks associated with the company.
Asset-based approach
When we take the asset-based approach, we can find value by subtracting the total liabilities from the total assets. This approach is applicable when a company’s worth is closely tied to its portfolio of assets.
So, we use this approach for companies in sectors like real estate or when a company is being dissolved.
Market-based approach
In the market-based approach, the first step we take is to find a comparable or group of companies that were recently involved in funding rounds or mergers and acquisitions (M&As). Then, we must calculate a valuation multiple by dividing the total valuation of all companies in the market by the total revenue of all companies. We can multiply the company’s financial figures by this valuation multiple to get its valuation.
Here, we are simply trying to answer the following question: How will this be priced by the current market if its equity is offered for funding or acquisition?
How does the Black-Scholes method value companies?
Before we dive into the Black-Scholes valuation method, let us first look at the asset class it was originally meant to value- options!
Options are defined as contracts to buy or sell an asset at a certain price at a future date.
If you believe a company’s stock price will increase in the future, you could purchase a call option that gives you the right to buy (call for) its stocks for a specific price lower than your expected stock. If you believe a company’s stock will fall, you could apply a similar strategy with put options which give you the right to sell its stock for a specific price.
However, with options, there is no guarantee on how much gain you will make and if you will make any gains at all. After all, reality could betray your expectations.
The Black-Scholes model’s strength lies in its ability to quantify the uncertainty of payouts or profits from options. We can observe a similar level of uncertainty in private equity, especially startups. We could say the same thing about distressed companies that often become targets of leveraged buyouts (LBOs). Hence, the Black-Scholes option pricing model was adapted to value companies.
The Black-Scholes model formula is as follows:
C=S×Nd1-K×e-rtN(d2)
The variables in this equation are as follows:
- C = Call option price
- S = Current stock price
- N = Normal distribution
- K = Strike price
- r = Risk-free rate of return
- t = Time to maturity
d1 and d2 can be calculated as follows:
- d1=ln SK +r+22tt / d2=d1-σt
Here, σ refers to the volatility in the stock price.
When we adapt the Black-Scholes model to value a company, we must change the following variables.
Symbol | Meaning in the original equation | Meaning in valuation exercises |
---|---|---|
C | Call option | Company valuation |
S | Current stock | Current value of the company’s assets |
K | Strike price | Company’s debt |
Changing C and S from call option price and current stock price to valuation and the current value of the company’s asset, respectively, should make intuitive sense. Let us see why we change K from strike price to company’s debt.
A shareholder has a lower payout preference than its creditors. When a company is dissolved, all debt must be paid off before shareholders are paid back. So, you can think of debt as a price shareholders must pay to receive the leftover funds.
Let us now visualize the parallels between debt in exercises and the strike in options with the help of a table.
Scenario | Call options | Company valuation |
---|---|---|
C > K | The stock price is higher than the strike price. Option holders can purchase the stock at a discounted price. | The value of the company’s assets exceeds its debt. Shareholders will receive the residual value after creditors are paid. |
C < K | The strike price is higher than the stock price. Option holders should not exercise the option since they will end up paying a premium for the stock. | The value of the company’s assets is less than its debt. Shareholders will not receive any residual value after creditors are paid. |
Which valuation method should you choose?
Throughout history, in any kind of advancement we make, we have strived to improve upon the shortcomings or limitations of existing tools. It is the same with valuation methodologies. Merton adapted the Black-Scholes model to value other assets including the equity in companies since traditional methodologies failed to account for the extreme uncertainty and volatility present in startups and distressed companies.
However, traditional valuation methods still offer accurate valuation insights for many companies. For instance, if a company is being targeted for acquisitions, it makes sense to use the market-based approach to understand the company’s price in current market conditions.
If is asset-heavy or about to be liquidated, we do not need to look further than the asset-based approach to find out its value to the shareholders.
The income-based approach offers a high degree of flexibility in valuing companies with varying types of revenue models. To deliver an accurate company valuation, all this approach requires is a detailed financial history spreading across various industries and economic conditions. This makes it the ideal candidate for valuing established companies with long financial histories.
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Traditional valuation methods offer reliable insights for companies with long financial histories, acquisition targets, asset-heavy companies, and companies that could be liquidated in the near future. In fact, to this day, wealth management professionals still widely use traditional valuation methods such as the market multiple method, discounted cash flow (DCF) method, and the book value method.
However, these valuation methods cannot fully capture the risks and uncertainty of startups and distressed corporations. Since the Black-Scholes model excels in this very area, it was adapted to value companies. Since this development, the Black-Scholes method has been used to value private equity assets.
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