Pertinence of real options approach to the valuation of internet companies

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. The problem is the valuation of uncertainty associated with the level of economic activity. Several approaches are used, including the concept of EVA (Economic Value Added) or Economic Profit, where certain modifications could be made in the evaluation of EVA. 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. 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 (EVA), and the discounted value of the future free cash Flows. The limits of these methods have also been discussed. 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. 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. The third section highlights the issues related to the identification of the embedded real options in the firm’s business plan. 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. 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. We also discussed how we identify the embedded options. In the last section we discuss the difficulties that are likely to be encountered and also the limits from a theoretical point of view of the real options method.