Real Options Valuation Market Investors Often Carry

Real Options Valuation

Market investors often carry out their research in a sell side or buy side method. Sell side carry out their investment research to enable them satisfy buy side customers. They carry out this research to generate business or reach the goal of generating transactions. The buy side follows the prospective of banking customers as away of attracting new customers and a service to past customers. Sell side firms sell IPO's and services to the buy side companies.

Buy side and sell side

Buy side reports produced in house consumption are used by colleagues to the analyst. These colleagues can be corporate development executives and development and portfolio managers. Sell-side reports done by firm analysts are vastly distributed than the buy side reports. Sell side reports should be clear because of their wide distribution, while by side reports should be simple and brief because company's management uses them. In the sell-side, the analyst has a twofold problem; the analyst has to reach a convincing decision by investigating an investment in a disciplined way and reaching a required wise decision. Secondly he must report in a tone and language convincing to others. This means that the analyst has to have contingent writing ability. A skilled analyst will simplify technical language, putting down key points enabling them to communicate effectively to the readers. A cogent analysis will start by a sort description of a company and ends with the recommendations.

The sell side is about communicating valuation analysis results through different methods. One can print the communication, pass it through emails, faxes or pass it verbally. On the buy side, one is paid to outperform the index without talking to anyone. As a sell side analyst, Martin works for brokers and dealers who sell the research to their buy side clients. Buy side has a form of investment while sell side clients use different types of money management disciplines.

While working for CSFB as a sell side analyst Martin was expected to satisfy three groups; the buy firms she advised, internal CSFB constituents and the companies she covered. Martin could be asked for expert advice, and her recommendations supposed to be reliable, this is because clients would consider participating in the deal in regards to martin's valuation about pricing and overall business. She recommended depending on the target and earning estimates of certain stocks.

On the buy side, Martin provided her recommendations to her manager, companies she worked for and her colleagues. Sell side conducts analysis, which is deeper, compared to the buy side. Structurers are involved in both the sell side and the buy side. In the sell side, trading and selling require structuring specialist to provide expertise. Trading structures provide information on how the structure can be changed and valuation services. Structurer security on the buy side exposes them to the market, which they cannot access and help them in opportunity identification for more benefit. Buy side create risks which the sell side along with Structurers work to mitigate.

Real options valuation

Martin decided to use real options method to valuate the stealth tier. Martin used the Black- Sholes model to value simple equity options. The approach she used was to value the option of stealth tier per every home passed. She approximated the current value for each stealth tier, by using an average current market value per home passed, for a typical cable company. She then divided the market value by the lit channels currently employed in order to get the current value of a channel per home passed. For the price of the option, martin calculated the cost of lighting up one of the seventeen channels. The costs of lighting up were minimal and close to zero, implying that use of stealth tier was intuitive. This intuition required homes to switch over to new applications when they could be available, and this was an expensive process which the cost was difficult to estimate.

Martin then considered a higher opportunity of not lighting up the fiber immediately. She estimated foregone profits with the current revenue stream per subscriber monthly or yearly. The penetration rate determined the annual revenue per year, which translated to $1.22 profit per channel passed. Martin then estimated the volatility for COX using a one month call option which estimates 50% volatility. She then used ten years as the maturity time, while she collected information from U.S. treasury about interest rates.

These inputs were then used to estimate options valuation. She then multiplied the result by the number of channels, to reach the total value of stealth tier. She netted out incremental costs and associated it with stealth tier installation corresponding to premium paid by the company for the cable option. The net value represented incremental 14% premium than the current valuation per home passed.

Logic

The logic used is appropriate because stealth tier provided 102 mHz unused capacity which according to her estimation was not valueless. DCF valuation was not satisfactory in valuing the unused channels. Martin thought the stealth tier was a real option to cable industries such as COX because; they could light up the stealth tier as a new or immature service.Real options valuation was the ideal valuation of stealth tier due to the uncertainty in the market. Real options valuations give managers a right to pursue investment projects without obligations to pursue the project. This makes this logic appropriate for this situation so I agree with this logic.

In Black-Scholes model; Martin Laura considered the European style optionto evaluate the valuation of stealth tier.She used the Black-Scholes model in equity options andpricing to value the call option.The choice to use the megahertz systems embedded a call option for future, unidentified opportunities making it appropriate. The financial theory as shown by Black Scholes model gives insights about businesses and shows the strategic investments per home passed. So this is agood approach.

Motivation

Martin Laura was motivated by the change in technology, emerging industrial structures and evolution in her industry, which made the traditional methods less effective. The upgrade of cable infrastructure has led to the creation of unused brand width capacity which could be used elsewhere. New markets are emerging this brings a lot of competition and uncertainty hence the real option is a strong strategic analysis. She was also inspired by the fact that stealth tier was being ignored by the market to the extent of not incorporating it into the valuation.