How to use a valuation framework with options – with Erik Kobayashi-Solomon
Applying your own valuation framework to options contracts and comparing it with market consensus is akin to playing poker and being able to see everybody else’s cards, says valuation expert Erik Kobayashi-Solomon
Even professionals investors can find the world of options a dauting place to visit but valuation expert Erik Kobayashi-Solomon, our latest guest on The Value Perspective podcast, is a very knowledgeable guide. We set out his entry-level take on the subject in How options can spice up investment but, to consider next how value investors might use options to their advantage, we must first cover off one further technicality.
When weighing up whether to buy an option that will offer you focused exposure to either the upside or downside potential of a business, the price of the options contract will clearly be an important factor. One approach to options pricing, known as the Black-Scholes Model, dominates all others in this regard – and, believes Kobayashi-Solomon, it is where value investors can find a winning hand.
“Everybody thinks of Black-Scholes as an option-pricing model but, at its heart, it is actually a probabilistic model of how asset prices behave,” he explains. “The option pricing bit is actually very easy. Say you have a probability of making $1 sometime in the future, and the probability of making that $1 is 10%, then the associated option should be worth 10 cents.”
Beware the consensus view
Underpinning the Nobel Prize-winning model’s assumptions is the so-called ‘efficient market hypothesis’ – the idea that, because investors work hard to evaluate every new piece of information, asset prices instantly reflect the consensus view of the information’s significance. As touched on in The Most Important Thing, however, where value investors can have an issue is in accepting the consensus view is necessarily correct .
“Remember, the model’s creators were working in the early 1970s so the efficient market hypothesis was the big deal,” points out Kobayashi-Solomon. “They were also looking at commodity prices to try to figure out how to model asset prices – commodities being huge in Chicago where they were working – so if you have any doubt about either aspect, you should be suspicious about the prices the Black-Scholes Model spits out.
“The model is still really useful for intelligent investors, though, because if they know how to read option prices, they can see exactly what probabilities the market is assigning to the future prices of stocks – and then they can simply compare that to what they think is reasonable. It is like sitting down at a poker table and not only being able to see your own cards but everybody else’s cards as well.”
To illustrate how this can help value-oriented investors to identify mispriced options contracts, Kobayashi-Solomon recalls an example from the height of the financial crisis in 2008. Trading at $10 a share at the time, he says, this particular company had no debt, boasted $8 per share of cash on its book and was generating 50 cents per share a year in cash.
“You do not have to be Warren Buffett or Charlie Munger to know that stock is probably worth at least $8 a share, which is a pretty hard downside,” Kobayashi-Solomon observes. “According to the option screens, however, the market was pricing in something like a 30% probability the price of this stock in three years’ time would be below $8.
“The fact is, the Black-Scholes Model does not know how much cash a company has on his books. It is based on the efficient market hypothesis – and that assumes, first of all, the current price is the value of the stock and the price movement is likely to be up or down. It is a probabilistic model of how asset prices behave but, because its assumptions are flawed, in certain cases, it gives the wrong price for options.
“In this case, the misconceived 30% chance the stock would fall below $8 made it an easy decision for me to just sell ‘put’ options and accept that downside risk – because I knew there was no downside risk. It was an arbitrage situation – like getting paid for nothing.” Not all such decisions are so easy, however, so how does Kobayashi-Solomon come up with his own data to compare against that of the Black-Scholes Model?
“About a third of my book, The Intelligent Option Investor, is actually dedicated to how to create a framework that will allow you to think about value in terms of range,” he replies. “The problem with human thinkers is we are not very good at assessing probabilities so the model I have pulled together in the book, and which I use myself when valuing companies, is to think about the three operational drivers that can create value.
“There is revenues – revenue growth and how you are responding to the demand environment. Next is profits – how efficient your company is in taking those revenues and converting them into profits. And then the last driver is future cashflow growth – at heart, how likely is it the projects you are investing in right now will succeed in driving cashflow growth in the future?
“If you know a company or an industry well, it is pretty easy to think about reasonable best and worst-case scenarios for each of those operational drivers. You combine all the worst-case values – worst-case revenues, worst-case profitability and worst-case assumptions about proper cashflow growth – to come up with a worst-case valuation and you do the same thing on the best-case side.
“One of the great things about thinking in a probabilistic perspective or thinking about value as range is you can compare your valuation range directly to the Black-Scholes Model. I said earlier it is like playing poker while being able to see all the other players’ cards – well, because you are thinking about your valuation the same way the market is, now you can compare your cards directly to what everybody else is holding.”
Fund Manager, Equity Value
I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.
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