Abstract
Commodity businesses have particular conditions that make them interesting from a financial valuation point of view; they usually operate globally, and their values are largely derived from underground reserves such as oil and gold. In this chapter, I discuss two financial valuation approaches adopted by practitioners and financial analysts applied to businesses operating in the commodity business and the natural resources. In particular, I cover the traditional Discounted Cash Flow (DCF) approach and the option models, offering practical examples.
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Notes
- 1.
FCF is the after-tax cash flow remaining after fulfilling investment needs (capital investment and net working capital NWC).
- 2.
FCFO = EBIT * (1 Tax Rate) + Non-Cash Expenses – Changes in NWC – Capex. Or FCFO = Cash Flow from Operations + Tax Adjusted Interest Expense – Capex. Other ways also exist.
- 3.
FCFE = Cash Flow from Operations – Capex + Net Debt Issued (repaid). Or FCFE = Net Income + Non-Cash Charges – Changes in NWC – Capex + Net Debt Issued (repaid). Other ways also exist.
- 4.
CAPM is an asset pricing model, it is used to calculate the remuneration for risky investments introduced and developed by Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently. However, exist other models for Ke calculation including the Fama-French three factor model, and the Arbitrage Pricing theory (APT).
- 5.
For example, if the company is in one continuous growth stage, we apply this version of the DCF: \(V = \frac{{CF_{0} \left( {1 + g} \right)}}{{\left( {wacc - g} \right)^{{}} }}\)
And if it is in two-stage growth, we apply this version of the DCF: \(V = \mathop \sum \limits_{t = 1}^{t = n} \frac{{CF_{0} \left( {1 + g_{1} } \right)^{t} }}{{\left( {1 + wacc} \right)^{t} }} + \frac{{CF_{n} \left( {1 + g_{2} } \right)^{{}} }}{{wacc - g_{2} }}\left( {1 + wacc} \right)^{ - n}\)
- 6.
If the company pays regular dividends, the following modified formula is applied \(Value_{call} = Se^{ - yt} N\left( {d1} \right) {-} Ke^{ - rt} N\left( {d2} \right)\) and \(d1 = \frac{{\ln \left[ {\frac{S}{K}} \right] + \left[ {r - y + \frac{\sigma 2}{2}} \right] *t}}{\sigma \surd t}\), where y is the dividend yield (D0/P0).
- 7.
We assume that the price is fixed for the whole duration with bilateral contracts, or the oil price has been normalized.
- 8.
You can also verify your manually calculated results using online Black–Scholes calculators or excel.
Further Readings
Berk, J., & DeMarzo, P. (2017). Corporate Finance (4th ed.). Pearson Education Limited. Pearson Italy: Milan.
Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637–654. https://www.jstor.org/stable/1831029.
Brealey, R., Myers, S., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). New York: McGraw-Hill Education.
Damodaran, A. (2003). Corporate Finance: Theory and Practice (2nd ed.). Chichester: Wiley.
Damodaran, A. (2005). The Promise and Peril of Real Options (NYU Working Paper). https://ssrn.com/abstract=1295849.
Damodaran, A. (2011). The Little Book of Valuation (Vol. 9, Issue 2). Hoboken: Wiley.
Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1), 13. https://doi.org/10.2307/1924119.
Mossin, J. (1966). Equilibrium in a Capital Asset Market. Econometrica, 34(4), 768–783. http://efinance.org.cn/cn/fm/EquilibriuminaCapitalAssetMarket.pdf.
Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance, 19(3), 425–442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x.
Treynor, J. L. (1961). Market Value, Time, and Risk. SSRN Electronic Journal, 1–46. https://doi.org/10.2139/ssrn.2600356.
Treynor, J. L. (1962). Jack Treynor’s Toward a Theory of Market Value of Risky Assets. SSRN Electronic Journal, https://doi.org/10.2139/ssrn.628187.
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Harasheh, M. (2021). Financial Valuation Aspects. In: Global Commodities. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-64026-2_5
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