Is the growth potential of stock prices underestimated? A real option approach

• Published in: International journal of business 2014-09, Vol.19 (4), p.336
• Main Authors: Levyne, Olivier, Heller, David
• Format: Article
• Language: English
• Subjects: Company growth; Discounted cash flow; Prices and rates; Stock prices; Stocks; Studies; Valuation
• ISSN: 1083-4346

Practitioners consider that the intrinsic value of equity is given by a discounted cash flow (DCF) valuation method. The Modigliani and Miller theory (1963) reveals that the cost of debt beyond the risk free rate has no impact on the weighted average cost of capital (WACC) and that the net debt which is included in the WACC computation is related to the amount which is in the firm's accounts. However, the net debt, which is deducted from the enterprise value to get the equity value, should be based on its economic value. The reference to the options literature (mainly Black & Scholes (1973), Merton (1973), Dixit and Pindyck (1994)) enables to propose a new breakdown of enterprise value between equity and net debt economic values. For healthy listed companies, the additional value embedded in the option model is not meaningful as evidenced by empirical tests. But, the main parameters of the model and one of its outputs, namely the recovery rate given default provides an explanation of the growth potential of the stock.