The Value of “Growth Options”

The Value of “Growth Options”

Financial economists divide the value of a company’s equity into two components: the value of “assets in place” and the value of “growth options.”  Although unfamiliar to many investors, the division is a highly useful tool.  To see why, both components must be defined clearly.  The first component, assets in place, has two parts.  The first part of assets in place is the cash on a company’s balance sheet net of its debt.  The second part is value the company could derive from its current earnings stream if it milked that stream for as long as it could without introducing new products and services.  The second component, growth options, is everything else.  Growth options represent the value of all the innovative things the company will do in the future.  This includes the new products it will sell, the new services it will offer, and the new ideas it will develop.  As such, it incorporates the value of innovations that, as of the current time, are not even imagined but which the market believes the creative people at the company will hit upon in the future.

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To actually divide the value of a company’s stock into the value of assets in place and the value of growth options requires making a number of assumptions and doing some financial mathematics.  For those who are interested, the process is described in leading MBA level finance textbooks such as Brealey and Myers.  I applied those techniques to six major technology companies: IBM, Apple, Facebook, Google, Amazon and Tesla as of the end of April 2016.  The results are presented in the chart below.

Several observations are worth making.  To begin, virtually all of IBM’s $145 stock price is accounted for by assets in place.  This is what you might expect for a mature company that is expected to grow and innovate slowly.  Apple is more surprising.  The value of the assets in place is greater than the stock price by $135.  This means the market expects Apple will be unable to effectively maintain its current position.  In contrast, for Google and Facebook much of the market value is accounted for by growth options.  At Facebook, more than 60% of the stock market value is attributable to future innovations that the market expects Mr. Zuckerberg and his team to produce.  Finally, at Amazon and Tesla virtually all of the market value is attributable to growth options.  That means if the companies fail to deliver on expected innovations, the market values will fall dramatically.

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The bottom line for investors is be aware of what you are paying for.  If you buy Apple, you are paying for a current earnings stream that is expected to decline.  If you buy Amazon or Facebook, you are paying for, in the large part, future innovations that have not yet seen the light of day.

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Bradford Cornell is an emeritus Professor of Financial Economics at the Anderson School of Management at UCLA. Prof. Cornell has taught courses on Applied Corporate Finance, Investment Banking, and Corporate Valuation. He is currently developing a new course on Climate Change, Energy and Finance. Professor Cornell has published more than 125 articles and four books on a wide variety of topics in applied finance. Professor Cornell is also a managing director at BRG where he heads the practice on Climate Change, Energy and Finance. In addition, he is a senior advisor to the Cornell Capital Group and to Rayliant Global Advisors. In both capacities, he provides advice on fundamental investment valuation.
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