FINANCIAL ANALYTICS

Unit – IV: Equity

Valuation

Dr. Dowlath Ahammad

Associate Professor
Dept. of MBA, CMRCET
Unit – IV: Equity Valuation:

 Calculation of Portfolio Mean and Variance,

Capital Asset Pricing Model (CAPM), Variance:
Covariance Matrix, Estimating Beta and
Security Market Line. Industry Analysis,
Economic Analysis and Technical Analysis in
Stock, Real Option in Capital Budgeting.
Portfolio Mean and Variance
 The mean and variance of a portfolio are key measures that investors
use to assess the performance and risk of their investment portfolios.
These calculations depend on the weights and returns of individual
assets within the portfolio.
 Assuming you have a portfolio with n assets, the mean (expected
return) and variance of the portfolio can be calculated as follows:
The Capital Asset Pricing Model
(CAPM)
 The Capital Asset Pricing Model (CAPM) is a financial model that
establishes a linear relationship between the expected return of an asset
and its systematic risk, often measured by beta. The model is widely
used in finance for estimating the required rate of return on an
investment.
 The formula for the CAPM is as follows:
Real Options
 The term ‘option’ is used to represent the choices a
firm has during various stages of the capital
investment process.
 The availability of a managerial or real option
increases the value of an investment project.
 In case the future is uncertain, there is higher chance
of exercising the options. This increases the value of
the options.
 Sometimes the firm recognises the presence of these
options and treats those informally and qualitatively.
 Real Option in Capital Budgeting

 A real option in capital budgeting refers to the flexibility

or strategic opportunity that a business has to make
decisions regarding its investment projects.
 Unlike financial options that involve financial
instruments like stocks or bonds, real options are
embedded in tangible assets and business operations.
 Real options provide managers with the flexibility to
adapt to changing circumstances and make decisions as
new information becomes available.
 The concept of real options recognizes that the value of an
investment is not solely determined by its expected cash
flows discounted at a risk-adjusted rate. It considers the
strategic flexibility and managerial choices that can
enhance or limit the project's value over time.
 Real options analysis involves estimating the value of these
options and incorporating them into the traditional
discounted cash flow (DCF) analysis. Techniques such as
decision trees and option pricing models (similar to those
used for financial options) are often applied to assess the
impact of real options on investment decisions.
Real Options and its Types

 Real option can be defined as the choice regarding new

business investment opportunities that may become
available.
 Effect of real options may greatly enhance the valuation of
capital investment proposals.
 The firm may have an option of expanding, downsizing or
abandoning of projects if business conditions change in the
future.
 The managements’ choices for such interventions are
called strategic options.
 Types of Real Options in Capital

Budgeting
Option to Expand (Scale): This option gives the company the right, but not the obligation, to
expand its operations or increase the scale of a project in the future. For example, a company
may build a plant with the option to expand production capacity if demand increases.
 Option to Delay (Timing): This option allows the company to delay the investment decision
until more information is available. Postponing the investment may be beneficial if there is
uncertainty about market conditions, technological developments, or other relevant factors.
 Option to Abandon (Shutdown): This option provides the right to abandon a project or
investment if it is not performing as expected. This is valuable when the business environment
changes or if the project becomes economically unviable.
 Option to Contract (Flexibility): This option allows the company to reduce the scale of
operations or divest part of the project. It provides flexibility to adapt to changing market
conditions or unforeseen challenges.
 Option to Switch (Mutual Exclusivity): This option allows the company to switch between
different types of projects or investment alternatives. It is valuable when there are multiple
opportunities, and the company wants the flexibility to choose the most profitable one.
 Real Options and its Types
 Some of the major real options are:

1. Growth Options
 When there is uncertainty in the scope of the project, the flexibility regarding
the size of facilities is important and constitutes the option.
 A project which has an option to expand will have higher initial cost to
establish the project, the excess cost being the option premium.
 A project which will have option to reduce the output in case the conditions
turn out unfavourable is called option to contract.
 The option to expand has value and the option to abandon also does.

 The projects which provide flexibility for changes are more valuable than
those which cannot be modified.
Real Options and its Types

2. Abandonment Option
 Capital investment projects generally involve huge amount of investment.

 To discontinue a project which has already been established is very expensive.

 In some cases dismantling or removal costs may have to be incurred in order to sell
away the equipment.

 The firms would like to have the option to exit from an investment which is not beneficial
anymore due to changed business conditions.
Real Options and its Types
3. Timing Option

 An investment idea which the firm evaluates may lead to negative NPV.

 In case the economic conditions change, the project may become profitable
and the NPV may turn out to be positive.

 If the firm has an option to postpone the timing of the project the project can
be accepted at that time.

4. Flexibility and Operating Options

 The firms often want to have flexibility in the capital projects which they can
utilise under changing environment.

 Flexibility implies having choices built into the equipment, which can be
utilised when the need arises.
Managerial Flexibility and
Commitment

 All firms operate under conditions of uncertainty all the time to a greater
or lesser degree.

 Firms would like to appropriately respond to continuously evolving

business conditions.

 The managers would like to have flexibility of ability to delay or

postpone a new project, enhance or diminish the size of an already
established project and abandon a project before its economic life.

 In order to consider strategic investments incorporating flexibility and

commitment, we need to look at the options available to the
management.
Implications and Cautions of Real Options
Approach
 The value of real options can be realised only if the options are exercised
optimally during the operation of the project.
 The management must be aware of the embedded optionality of the
project.
 The evaluation of an investment project based on real options is more
difficult and requires greater time, effort and judgement.
 If the advantage gained by the use of real option is less than the cost of
option or at times there is no gain at all?
 Another issue to be kept in mind is whether the advantages due to
options are sustainable.