Option method in business valuation

option method in business valuation
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  • Real Options in Business Valuation Monday, November 14, Business valuation is a complex area that underpins a critical part of modern finance.
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  • Pertinence of real options approach to the valuation of internet companies | SpringerLink

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.

The WACC method determines the subject company's actual cost of capital by calculating the weighted average of the company's cost of debt and cost of equity. The WACC must be applied to the subject company's net cash flow to total invested capital. One of the problems with this method is that the valuator may elect to calculate WACC according to the subject company's existing capital structurethe average industry capital structureor the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics. Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation.

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.

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The problem is the valuation of uncertainty associated with the level of economic activity. We propose in this paper the approach based on real options which are particularly suitable for valuation of uncertainty.

The paper takes the case of a real internet company to illustrate the approach, and highlights the difficulties which are encountered.

Valuation of Early Stage Startups (Part 1) - Overview for Investors - Crowdwise Academy (315)

The paper is divided in six sections; the second section after the initial introduction discusses the traditional methods of valuation of companies. The methods discussed include: approaches based on benchmarking, the present value of Economic Value Added EVAand the discounted value of the future free cash Flows. The limits of these methods have also been discussed.

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The second chapter describes briefly the theory of Real options, and how it can be used to value companies. The stress is on the problems related to valuing uncertainty.

Furthermore, valuation of natural resources companies also pose similar challenges. What if? Traditional valuation methods e.

The key issue in the valuing of internet or new economy companies is the uncertainty of the future cash flows that these companies are likely to generate, as the economic and technological environment in which these firms operate are subject to rapid changes which are difficult to predict. We underline the importance for the analyst to understand the sector in which the firm operates and also the likely changes that could take place in the technological options of the firm.

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In the fourth section the real options approach is used to value two internet companies. The different parameters that need to be estimated for using the real options method are indicated.

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.

We also discussed how we identify the embedded options. In the last section we discuss the difficulties that are option method in business valuation to be encountered and also the limits from a theoretical point of view of the real options method.

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