After estimating the incremental cash flows from optionality, we need to estimate this uncertainty from cashflows in the form of a standard deviation in the value of the cash flows.The only problem that i have is making these estimates, as i dont have enough information on Zomato's competitive advantage in these potential markets, but that is precisely where the option value is derived. I estimate the expected value of Zomato on this premise and factor the cost of going ahead with the expansion option today: I forecast the incremental cash flows coming from this optionality. I assume Zomato would move to groceries and compete with Big Basket.But, if i value Zomato given its optionality to expand from food delivery markets to other markets, what are the uncertainties that i would face when estimating its value? Let us take the case of Zomato, and when i value Zomato with an assumption that it would continue to be in the food delivery markets, i get the value/share at Rs.35, which is far less than the subscribed price. Valuing Real Options to expand in Startups This learning and adaptive behavior give rise to the option value. The second is that Apple and Microsoft would have learned a lot at the launch of iPod or MS Office and would have incorporated those learnings or not repeated the same mistakes when they launched the following products.Even the companies like Apple and Microsoft that expanded would not have been able to visualize the potential markets for Microsoft Office or the iPhone when introducing MSDOS or the iPod. First, our forecasts about these potential product and market expansions will be very unclear at the initial valuation, and the cash flows will reflect this uncertainty.Now the big question is, what prevents us from adding these cashflows in our conventional DCF. Mc Donalds, Coke, and KFC are examples of successful brands in the US that expanded to other countries by customizing their menus to suit local cultures. We can expand Apple's analogy to Microsoft and Facebook, which launched multiple products or expanded their TAM.Ĭompanies have expanded through geographies where success in one market gave companies the confidence to expand to other countries. As an investor valuing Apple when it launched iPod, i would not have added cash flows from its smartphone segment and thus would have undervalued Apple. Currently, the majority of Apple's value comes from smartphones. However, Apple started expanding to the smartphones and wearables segment. For instance, Apple's success was initially on the iPod, and if i had valued Apple at that time, my cashflows would rely on the TAM for iPod and Apple's continued expansion of market share in the iPod market. ![]() Still, if the firm expands to other markets, the additional cash flows from the expansion do not get captured. However, the assumptions in our model are on how the firms will capture additional market share as the market expands. ![]() Thus, the model captures the potential cashflows, and the valuation reflects this upside. In a conventional DCF or relative valuation, we develop financial models on the realistic potential of a startup's success in terms of revenues and earnings. ![]() In this post, i provide insights into the importance of Real Options in Valuation and how adding optionality to your DCF will help you value companies better. Thus, i got my thinking hat and analyzed if i was missing anything in my valuations or anything that the conventional DCF method could not capture. Yet, when i value the above companies by the conventional DCF, i invariably get a high discount to the price they command. From Uber to Lyft to Zomato and Paytm, these are the arguments given by the founders. The argument given for these high valuations is their growth potential, and with growth, these companies would find a path to profitability. Most of these IPOs are not profitable, but their valuations are steep. Almost one in every three IPOs listed in global stock markets are startups/unicorns.
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