Opportunity to Expand Vs Option to Expand – The Valuation Perspective
The assumptions for valuations are so subjective that you would find myriad views on that. However, it is also true that those assumptions should be well backed with good evidence or rationale. Recently, I had a discussion on real options with an option purists. He argued that if a company wants to enter or exploit a new market, there could be options embedded in those investments and those investments should be valued using options. So, are real options a more reliable way to value these type of investments or projects?
Before we conclude that, let us understand this with an example. One of our clients, a medtech company, wants to enter India. If we have to value this project, should we use Options or DCF to value it? When we value with options, we are implicitly adding a layer of premium on the top of the DCF valuation. What is so special about this project that demands an option valuation. Let us explore the following questions to understand more:
- Is the company the first one or the only one to enter the new market?
- Are there any competitive advantages it would obtain on entering the new market?
- Is there any degree of exclusivity in terms of any favor shown by the government, or distributor/partner who has rights to service a huge portion of the market?
- Do those exclusive rights to the market come with any pricing power?
The issue here is that the option to expand in India is open to all other Medtech companies and not just the company in question. There are definitely potential advantages to justify the investments for expanding into India. However, not all of the projects create valuable options. The value of options is derived from the degree to which the competitive advantages ( if it exists) turn into excess returns and these advantages could be justified to add premiums only if there is some degree of exclusivity in the targeted market.