Damodaran on Valuation

18.5. WHEN SHOULD WE USE THE OPTION PRICING MODELS?

In Chapter 12, we presented a number of scenarios where option pricing may yield a premium on traditional discounted cash flow valuation. We do not intend to revisit those scenarios, but offer the following general propositions that we should keep in mind when using option pricing models.

• Use options sparingly. Restrict your use of options to where they make the biggest difference in valuation. In general, options will affect value most at smaller firms that derive the bulk of their value from assets that resemble options. Therefore, valuing patents as options to estimate firm value makes more sense for a small biotechnology firm than it does for a drug giant like Merck. While Merck may have dozens of patents, it derives much of its value from a portfolio of developed drugs and the cash flows they generate.

• Opportunities are not always options. We should be careful not to mistake opportunities for options. Analysts often see a firm with growth potential and assume that there must be valuable options embedded in the firm. For opportunities to become valuable options, we need some degree of exclusivity for the firm in question—this can come from legal restrictions on competition or a significant competitive edge.

• Do not double count options. All too often, analysts incorporate the effect of options on fundamentals in the company value and then proceed to add on premiums to reflect the same options. Consider, for instance, the undeveloped ...