Terminal Values For Firms With Growth Opportunities: Explaining Valuation and IPO Price Behavior

The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1086-7376.htm
SEF
35,2 Terminal values for firms with
growth opportunities: explaining
valuation and IPO price behavior
244 Tom W. Miller
Department of Economics, Finance and Q.A., Kennesaw State University,
Received 27 March 2016 Kennesaw, Georgia, USA
Revised 10 February 2017
Accepted 17 March 2017
Abstract
Purpose – The purpose of this paper is to use fundamental models incorporating structural relationships
within the firm in a terminal value model for the second stage of a two-stage valuation model utilized to
estimate the value of a company.
Design/methodology/approach – The innovation is that growth options are identified within the
structural relationships and a model capturing the value of the optionality is incorporated in the second stage
of the two-stage valuation model.
Findings – Significant outcomes are that terminal value is shown to be a large portion of a company’s total
value and the price behavior for initial public offerings produced by the model is consistent with the result of
empirical studies.
Originality/value – This paper explicitly incorporates growth options in the second stage of a two-stage
valuation model for the firm.
Keywords Valuation, Growth options, Growth opportunities, IPO pricing, Terminal value
Paper type Research paper
1. Introduction
Two-stage valuation models are often used to estimate the value of a company. The first
stage is called the explicit forecast period. The second stage is called the continuing value
period. The continuing value period includes all of the time periods after the explicit forecast
period. It is usually treated as a steady state with constant stable long-term relationships.
The value of the cash flows occurring during the continuing value period is estimated using
a terminal value model. A constant growth model with a constant perpetual growth rate and
constant cost of capital is usually used to estimate the terminal value (Damodaran, 2012;
Fernandez, 2002; Holthausen and Zmijewski, 2014; Koller et al., 2015). Either stage may be
designed to permit competitive advantages and disadvantages (Mauboussin and Johnson,
1997). Typically, when a two-stage valuation model is used, a large portion of the value of
any firm comes from its terminal value. Terminal value has often been the source of much of
the criticism of the discounted cash flow approach to valuation. Critics argue that terminal
value is easy to manipulate to produce any number that is wanted. It is argued that
unreasonably large competitive advantages or unreasonably large long-term sustainable
growth must be used to inflate the terminal value so that reasonable values for the company
are produced. Often there is considerable uncertainty and debate about the appropriate rate
for long-term sustainable growth which center on discussions of constraints on growth
Studies in Economics and Finance
Vol. 35 No. 2, 2018 imposed by the economic system, industry or market (Damodaran, 2012; Fernandez, 2002;
pp. 244-272
© Emerald Publishing Limited
1086-7376
DOI 10.1108/SEF-03-2016-0078 JEL classification – G12, G31
Koller et al., 2015). The terminal values of actual companies may appear to be too large Terminal
because they incorporate the value associated with the optionality of growth opportunities. values for
This research uses fundamental models which incorporate structural relationships
within the firm in the terminal value model. The innovation in this study is that growth
firms
options are identified within the structural relationships for the company during the
continuing value period. An explicit valuation model for growth options is introduced into
the terminal value model. This model captures the incremental value of the optionality of the
growth opportunities available to the company. Although growth options are usually 245
thought to be important for young firms, growth options are important in the valuation of
both young firms and older firms where technology is changing significantly. The resulting
model for terminal value incorporating the model for growth options is used to examine the
magnitude of the terminal value produced during the continuing value period and compare
it to the terminal value produced during the continuing value period when a constant
growth model is used. A significant outcome is that a company’s terminal value can be a
large portion of the company’s total value without making unreasonable assumptions about
large competitive advantages or large steady-state growth rates that are greater than the
growth rate for the economy. The large contribution of the terminal value to the total value
of the company comes from the value of the optionality of the growth opportunities that are
available to the company in the continuing value period.
Terminal value models for two-stage valuation models with growth options within the
structural relationships for the firm generate price behavior for firms that have initial public
offerings which is consistent with the findings of empirical studies. Empirical studies have
shown that on average, companies that have had an initial public offering have very large,
positive first-day abnormal rates of return and substantial negative abnormal rates of return
over the subsequent three to five years. When the initial public offering price is based on a
two-stage valuation model that does not recognize the optionality of the growth
opportunities occurring during the continuing value period and the subsequent market
prices are based on a two-stage valuation model that does recognize the optionality of the
growth opportunities occurring during the continuing value period, the price behavior for
initial public offerings is consistent with the empirical studies.
Schwartz and Moon present a basic version (Schwartz and Moon, 2000) and an expanded
version (Schwartz and Moon, 2001) of a simulation-based valuation model for high-growth
companies. Monte Carlo simulation is used to generate values for a company while taking
path-dependencies into account. The basic version of the model has two sources of
uncertainty:
(1) uncertainty about the change in revenues; and
(2) uncertainty about the expected growth rate for revenues.
The expanded version of the model has three sources of uncertainty: uncertainty about
changes in revenues, uncertainty about changes the expected growth rate for revenues and
uncertainty about variable costs. Both versions of the model have an explicit forecast period
and a terminal value capturing the continuing value of the company occurring after the
explicit forecast period. In both versions of the model, the terminal value is a multiple of
earnings before interest, taxes, depreciation and amortization. Both versions of the model
include the value of an option for the company to go bankrupt with limited liability at any
time during the explicit forecast period if the cash balance or value of the company is too
low. This abandonment option can be quite valuable when the volatility is high.
In the basic version of the model, the net after-tax cash flow is equal to revenues minus
costs times one minus the corporate tax rate. In the expanded version of the model, the net
SEF after-tax cash flow is equal to revenues minus costs and depreciation time one minus the
35,2 corporate tax rate. In the basic version of the model, the cash available to the firm equals the
beginning cash available to the firm plus interest earned on the beginning cash available to
the firm plus net after-tax cash flow. In the expanded version of the model, the cash
available to the firm equals the beginning cash available to the firm plus interest earned on
the beginning cash available to the firm plus net after-tax cash flow plus depreciation minus
246 capital expenditures. In both versions of the model, the net after-tax cash flow remains in the
company and is not paid out as dividends. The cash available at any point in time during the
explicit forecast period determines when bankruptcy occurs. The company goes bankrupt
and exercises its abandonment option when the cash balance reaches zero in the basic
version of the model and when the cash balance reaches a trigger point for bankruptcy that
allows for additional external financing in the expanded version of the model. In both
versions of the model, the value of the company is equal to the present value of the net after-
tax cash flow generated during the explicit forecast period plus the present value of the
terminal value.
The basic version of the model with an explicit forecast period of 25 years is used
generate values for Amazon. The terminal value of Amazon is equal to 10 times earnings
before interest, taxes, depreciation and amortization at the end of 25 years. The expanded
version of the model with an explicit forecast period of 10 years is used generate values for
eBay. The terminal value of eBay is equal to 10 times earnings before interest, taxes,
depreciation and amortization at the end of 10 years. Optionality is not included in the
terminal value of either version of Schwartz and Moon’s simulation-based valuation model
for high-growth companies. The innovation in this study is that optionality is included in
the terminal value of the valuation model.
The rest of the paper is organized in the following manner. The next section presents
two-valuation models which are often used to estimate and value the firm’s expected future
cash flows. Fundamental models which incorporate structural relationships within the firm
are introduced for the cash flows. The second section focuses on the value produced during
the continuing value period of the two-stage valuation model. Growth options (Berk et al.,
1999; Jacquier et al., 2010; and Myers, 1977) are shown to be embedded in the growth
opportunities that are available to the firm during the continuing value period. Kraft et al.
(2013) study the extent to which firm value is related to growth options and find strong
empirical evidence that firm value is significantly positively affected by the presence of
growth options. Li (2016) examines how the dividend payout ratio impacts future stock
returns and momentum profits and finds that the dividend payout ratio has a significant
impact on future stock returns and momentum profits and that the impact is the largest
among stocks that make no dividend payments. A growth option idea is used to provide a
rational explanation for these empirical results. The dividend payout ratio can have a
significant impact on stock returns because the smaller the dividend payout ratio the larger
the proportion of earnings that are retained by the firm to make investments in growth
options. Investments in growth options affect the firm’s future cash flows and asset risk.
When firms have more growth opportunities, they tend to pay out less as dividends and
retain more earnings. The dividend payout ratio can be thought of as an indicator of
investments in growth options. This is why the momentum profit is the largest among the
stocks that make no dividend payments. The third section of the paper presents the
exchange option model as a way to capture the optionality of the growth opportunities
available to the firm during the second stage of the valuation model. The following section
uses an illustrative numerical example to show that the terminal value of the firm can be
significantly larger when the optionality of the growth opportunities available to the firm is
recognized when compared to the terminal value when the optionality of the growth Terminal
opportunities is ignored. This misspecification of the two-stage valuation model causes values for
valuation challenges which lead to inflation of predicted sustainable growth rates and
competitive advantages occurring during the continuing value period. The fifth section of
firms
the paper shows that the optionality of the growth opportunities available to the firm during
the continuing value period provides an explanation of the observed price behavior for
initial public offerings. When the initial public offering price is based on a two-stage
valuation model that does not recognize the optionality of the growth opportunities 247
occurring during the continuing value period and subsequent market prices are based on a
two-stage valuation model that does recognize the optionality of the growth opportunities
occurring during the continuing value period, first-day abnormal rates of return are positive
and substantial and subsequent abnormal annual rates of return are consistently negative
and decrease as the number of years since the initial public offering increase. The final
section of the paper provides a summary of the study and presents the major findings. This
study shows that the optionality of the growth opportunities available to firm during the
continuing value period provides an explanation for valuation challenges faces by financial
analysts and the price behavior of initial public offerings.
2. Two-stage valuation models

Two-stage valuation models are used in this study. A company’s expected future free cash
flows are separated into two periods to estimate a company’s value (Damodaran, 2012;
Fernandez, 2002; Koller et al., 2015). The first future period, the explicit forecast period, is
typically the first five to ten future years. Detailed financial statements are estimated for this
period and used to provide supporting information for expected free cash flows. The value
produced by the company during the explicit forecast period is equal to the present value of
the forecasted expected free cash flows:
XT
FCFt
VEF0 ¼ t (1)
t¼1 1 þ RÞ
ð
VEF0 is the value at time 0 that is produced during the explicit forecast period, FCFt is the
expected free cash flow for year t, R is the annual cost of capital for the company and T is the
number of years in the explicit forecast period. The second future period is the continuing
value period. The continuing value period is the rest of the future after the explicit forecast
period. The terminal value of the company at the beginning of the continuing value period is
the present value of the expected future free cash flows occurring after the explicit forecast
period. For the continuing value period, free cash flows are not explicitly forecasted and
discounted. For this period, a valuation model is used to estimate the terminal value of the
company at time T. The terminal value at time T is discounted to determine the contribution
of the terminal value to the total value of the company at time 0:
TVT
TV0 ¼ (2)
ð1 þ RÞT
TV0 is the value at time 0 that is produced during the continuing value period and TVT is
the value at time T that is produced during the continuing value period. The total value of
the company at time 0 is the sum of the value that is produced during the explicit forecast
period and the value that is produced during the continuing value period:
SEF V0 ¼ VEF0 þ TV0 (3)
35,2
V0 is the total value of the company at time 0. It is important that the terminal value be
estimated carefully because terminal value has been shown to account for a very large
portion of the value of a company. Previous research has shown that, when an explicit
forecast period of eight years is employed, terminal value accounts for 56 per cent of the
248 total value of tobacco companies, 81 per cent of the total value of sporting goods companies,
100 per cent of the total value of skin care companies and 125 per cent of the total value of
high tech companies (Koller et al., 2015). The value produced by the cash flows occurring
during the explicit forecast period for high tech companies is a negative 25 per cent of total
value of the companies. Terminal value is often a very large portion of total value because
companies are investing large amounts (large capital expenditures and increases in net
working capital) in the early future years making expected free cash flows small or negative
during the explicit forecast period. Such investments are expected to generate higher
expected free cash flows in later years.
A stable growth model is often used to estimate the terminal value of a going-concern at
the end of the explicit forecast period for a company that is assumed to have an infinite life.
The company is expected to make future investments to renew itself. As the company
invests and grows and faces increased competition, it will be more difficult for it to grow.
Eventually, the company will enter a steady state. When this happens, the company’s
growth rate stabilizes and is bounded by the growth rate of the economy (Fabozzi and
Grant, 2000; Holthausen and Zmijewski, 2014; Koller et al., 2015; Pinto et al, 2015). In the
steady state, the company will grow at a stable growth rate that can be maintained forever
during the continuing value period. This stable growth rate is assumed to be constant and is
used in a valuation model for a growing perpetuity to determine the terminal value at time T
that is produced during the continuing value period:
FCFTþ1
TVT ¼ (4)
Rg
FCFTþ1 is the expected free cash flow for year T þ 1, T þ 1 is the first year of the continuing
value period and g is the constant stable growth rate. TVT is discounted to determine the
value at time 0 that is produced during the continuing value period, TV0.
Free cash flow is the measure of cash flow for a company that is used to value the
company (Damodaran, 2012; Fernandez, 2002; Koller et al., 2015). Free cash flow at time t,
FCFt, is defined as being equal to the net operating profit after taxes at time t, NOPATt, less
the required net investment for time t, NINVt. The model for free cash flow for the company
at time t is:
FCFt ¼ NOPATt NINVt (5)
Net operating profit after taxes at time t is usually calculated as earnings before interest and
taxes, EBITt, after taxes:
NOPATt ¼ ð1 t Þ EBITt (6)
In the model for net operating profit after taxes, t is the cash income tax rate. Net
investment for the company at time t is equal to the change in the book value of capital, the
invested capital, DBVCt:
NINVt ¼ DBVCt ¼ BVCt BVCt1 (7) Terminal
The total amount of invested capital, also called investor-supplied funds, is: values for
firms
BVCt ¼ BVDt þ BVPSt þ BVEt (8)
where BVDt is the book value of interest-bearing debt at time t, BVPSt is the book value of
preferred stock at time t and BVEt is book value of common equity at time t. The book value
of capital at time t is equal to the total amount of investor-supplied funds. 249
3. Fundamental model for the terminal value of a company

Given the definition of free cash flow, the valuation model for the terminal value of the
company at time T is:
FCFTþ1 NOPATTþ1 NINVTþ1

TVT ¼ ¼ (9)
Rg Rg
where R is the cost of capital. This model can be converted to a more revealing form by
multiplying NOPATTþ1 by (R/R) and adding:
ðg=RÞ NOPATTþ1 ðg=RÞ NOPATTþ1 (10)
to the numerator to obtain:
ðR=RÞ NOPATTþ1 NINVTþ1 þ ðg=RÞ NOPATTþ1 ðg=RÞ NOPATTþ1

TVT ¼
Rg
(11)
which simplifies to:

g NOPATTþ1
NOPATTþ1 R NINVTþ1
TVT ¼ þ (12)
R Rg
The first term on the right-hand side of this equation for terminal value is the value at time T
of continuing existing operations and the second term on the right-hand side of the equation
for terminal value is the net present value at time T of growth opportunities occurring
during the continuing value period:
TVT ¼ VOPT þ NPVGOT (13)
NOPATTþ1
VOPT ¼ (14)
R
and:

g NOPATTþ1
R NINVTþ1
NPVGOT ¼ (15)
Rg
SEF VOPT is value at time T of continuing existing operations during the continuing value
35,2 period and NPVGOT is the net present value at time T of growth opportunities
occurring during the continuing value period. The net present value at time T of growth
opportunities during the continuing value period is equal to the value at time T of
growth opportunities during the continuing value period minus the value at time T of
the additional invested capital required by the growth opportunities during the
250 continuing value period:
NPVGOT ¼ VGOT VICT (16)

g NOPATTþ1
R
VGOT ¼ (17)
Rg
and:
NINVTþ1
VICT ¼ (18)
Rg
VGOT is the value at time T of growth opportunities during the continuing value period and
VICT is the value at time T of the additional invested capital required by the growth
opportunities during the continuing value period.
The rate of return on capital for existing operations for the company for the steady state
is:
NOPATTþ1
ROCOP ¼ (19)
BVCT
and the rate of return on capital for growth opportunities for the company for the steady
state is:
g NOPATTþ1
ROCGO ¼ (20)
NINVTþ1
where g · NOPATTþ1 is the incremental net operating profit at time T þ 2. Using the
definition of the rate of return on capital for existing operations, the model for the net
operating profit after taxes for existing operations becomes:
NOPATTþ1 ¼ ROCOP BVCT (21)
Using the definitions of the rate of return on capital for growth opportunities and the
incremental book value of capital, the model for the incremental net operating profit after
taxes for growth opportunities is:
g NOPATTþ1 ¼ ROCGO NINVTþ1 (22)
Substituting these relationships into the model for terminal value indicates that:

ROCOP BVCT
ROCGO NINVTþ1
R NINVTþ1 Terminal
TVT ¼ þ (23) values for
R Rg
firms
which can be written as:

ROCOP ROCGO NINVTþ1 NINVTþ1
TVT ¼ BVCT þ (24) 251
R R Rg Rg
to reveal important relationships. (ROCOP/R) is a measure of the competitive advantage

or competitive disadvantage for the company’s existing operations. When (ROCOP/R) is
greater than one, the company has a competitive advantage with respect to its existing
operations. When (ROCOP/R) is less than one, the company has a competitive
disadvantage with respect to its existing operations. When (ROCOP/R) equals one, the
company has neither a competitive advantage nor a competitive disadvantage with
respect to its existing operations. (ROCGO/R) is a measure of the firm’s competitive
advantage or competitive disadvantage for the company’s growth opportunities. When
(ROCGO/R) is greater than one, the company has a competitive advantage with respect
to its growth opportunities. When (ROCGO/R) is less than one, the company has a
competitive disadvantage with respect to its growth opportunities. When (ROCGO/R)
equals one, the company has neither a competitive advantage nor a competitive
disadvantage with respect to its growth opportunities. The company may have a
competitive advantage with respect to either its existing operations or its growth
opportunities. The company may have a competitive disadvantage with respect to
either its existing operations or its growth opportunities. The company may have
neither a competitive advantage nor a competitive disadvantage with respect to either
its existing operations or its growth opportunities. When (ROCOP/R) equals one and
(ROCGO/R) equals one, the terminal value at time T equals the book value of capital at
time T, BVCT.
The value at time 0 that is produced during the continuing value period is equal to the
value at time 0 of continuing existing operations during the continuing value period plus
the value at time 0 of growth opportunities during the continuing value period minus the
value at time 0 of the additional invested capital required by the growth opportunities
during the continuing value period:
TV0 ¼ VOP0 þ VGO0 VIC0 (25)
where VOP0 is the value at time 0 of continuing existing operations during the continuing
value period, VGO0 is the value at time 0 of growth opportunities occurring during the
continuing value period and VIC0 is the value at time 0 of the additional invested capital
required by the growth opportunities during the continuing value period. The value at time
0 of continuing existing operations during the continuing value period is:
" #
NOPATTþ1 ðROCOP =RÞ
VOP0 ¼ T
¼ BVCT (26)
R ð 1 þ RÞ ð1 þ RÞT
The value at time 0 of growth opportunities occurring during the continuing value
period is:
h i
SEF g NOPATTþ1 " #
R ðROCGO =RÞ NINVTþ1
35,2 VGO0 ¼ ¼ (27)
T
ð1 þ RÞ R g ð 1 þ RÞ T Rg
The value at time 0 of the additional invested capital required by the growth opportunities
during the continuing value period is:
252
NINVTþ1
VIC0 ¼ (28)
ð1 þ RÞT ðR gÞ
The constant growth model, which is often used for the continuing value period of a two-
stage valuation model, assumes that the company has an obligation at time 0 to invest in the
growth opportunities that are available in the continuing value period. However, at time 0,
the company has the right, but not an obligation to invest in the growth opportunities that
are available in the continuing value period. Therefore, at time 0, the company owns a
European exchange option on the growth opportunities occurring during the continuing
value period. Previous valuation models for terminal value have treated the growth
opportunities occurring during the continuing value period as an obligation and not as an
option. This implicitly assumes that the company has already decided to make the required
investments. As the right to wait to make the decision about making the investments
required by the growth opportunities is valuable, previous valuation models tend to
underestimate the value of growth opportunities occurring during the continuing value
period tempting analysts to inflate estimates of competitive advantages and long-term
growth rates to compensate for the undervaluation resulting from the misspecification the
model.
4. An option model for growth opportunities

An option valuation framework is required to capture the additional value of the optionality
of the growth opportunities occurring during the continuing value period. Either a variant of
the Black-Scholes-Merton option pricing model for a European exchange option (Black and
Scholes, 1973; and Merton, 1973a, 1973b) or a binomial tree for a European exchange option
(Rubinstein, 1991) may be used to estimate the value of the growth option that expires at the
end of the explicit forecast period, time T. A Black–Scholes–Merton option pricing model for
a European exchange option is used in this paper for expository reasons, but a binomial tree
can be used. The company owns a growth option for growth opportunities that are available
because of its knowledge, experience, expertise and resources. The growth option is an
exchange option giving the firm the right, but not the obligation, to invest in future
operating activities created by previous investments and previous operating activities. The
exercise price of the growth option is the value at time T of the additional invested capital
required to exploit the growth opportunities occurring during the continuing value period.
A standard European call option allows the value of one set of assets to be exchanged for
a fixed amount of cash. Growth opportunities may be modeled by using a standard
European call option on the value of the underlying assets when the amount paid when the
option is exercised is deterministic. The special feature a European exchange option is that it
allows the value of one set of risky assets to be exchanged for value of another set of risky
assets. For example, the value of risky investment costs for a project can be exchange for the
value of risky benefits for the project. The payoff at expiration for a European exchange
option is the maximum of zero or the difference between the value of the underlying risky
assets (the benefits) and the value of the risky assets exchanged for the underlying assets Terminal
(the investment costs). When growth opportunities are modeled by using a European values for
exchange option rather than a standard European call option, it allows both the value of the
underlying assets (the benefits) and the value of the assets exchanged for the underlying
firms
assets (the investment costs) to be risky variables. A standard European call option can be
thought of as a European exchange option when one of the assets is not risky.
253
4.1 A pricing model for a European exchange option
Exercising any option involves exchanging assets. A call option on a stock is an exchange
option for which a stock has to outperform cash for the option to pay off. A put option on a
stock is an exchange option for which cash has to outperform a stock for the option to pay
off. A general exchange option gives the owner of the option the right, but not the obligation,
to exchange one risky asset for another risky asset (Margrabe, 1978; and Bjerksund and
Stensland, 1993). A variant of the Black–Scholes–Merton option pricing model can be used
to value a European exchange option (Black and Scholes, 1973; Chriss, 1997; Jarrow and
Rudd, 1983; Merton, 1973a, 1973b; and Neftci, 2000). The value of a European exchange
option with a time to expiration of T is equal to:
E0 ¼ A0 edA T Nðd1 Þ X0 ed X T Nðd2 Þ (29)
h i
A0 e dA T
ln X0 e d X T
þ 12 s 2 T ln AX00 þ d X d A þ 12 s 2 T
d1 ¼ pffiffiffiffi ¼ pffiffiffiffi (30)
s T s T
pffiffiffiffi
d2 ¼ d1 s T (31)
and:
s 2 ¼ s 2A þ s 2X 2 rs A s X (32)
E0 is the value of the European exchange option with time until expiration of T years. A0 is
the value of the asset and X0 is the value at time 0 of the benchmark asset. d A is the rate of
return shortfall for A0 and d X is the rate of return shortfall for X0. d1 and d2 are standard
normal variables. N(d1) and N(d2) are cumulative normal probabilities. s A is the volatility of
A0 and s X is the volatility of X0. r is the correlation between the continuously compounded
rates of return on the two assets. In this variant of the Black–Scholes–Merton model, the
risk-free rate of return is replaced by the rate of return shortfall on the benchmark asset, d X.
s is the volatility of the difference between the continuously compounded rates of return on
the two assets.
The valuation model for a European exchange option can be used to value ordinary calls
and puts. To use this model, the rate of return shortfalls and volatilities must be set
appropriately. A call option on a stock requires that cash be given up to acquire the stock.
The rate of return shortfall for cash is the risk-free rate of interest. The volatility for cash is
zero. For call options on stock, d X = r and s X = 0. A put option on stock requires that a
stock be given up to acquire cash. The rate of return shortfall for cash is still the risk-free
rate of interest and the volatility for cash is still zero. For put options on stock, d A = r and
s A = 0.
SEF When the valuation model for a European exchange option is used to estimate the
35,2 value of the growth opportunities occurring during the continuing value period for a
company, A0 in the exchange option model equals VGO0, X0 in the exchange option
model equals VIC0, d A in the exchange option model equals zero, d X in the exchange
option model equals zero, s A in the exchange option model is the volatility of VGO0, s X
in the exchange option model is the volatility of VIC0, r in the exchange option model is
254 the correlation between the continuously compounded rates of return on the two assets
and s in the exchange option model is the volatility of the difference between the
continuously compounded rates of return on the two assets. The value at time 0 of the
right, but not the obligation, to invest in the growth opportunities occurring during
the continuing value period equals E0.
4.2 Correlation between the rates of return for VGO0 and VIC0
The rates of return on the two assets can be correlated. A single-factor model for rates of
return is used to determine possible values for the correlation between the rates of return for
the cash flows for the value of growth opportunities and the value of the invested capital
required by the growth opportunities. The rates of return may be related to the rate of return
on the market portfolio by a single-factor model such as the classic Sharpe/Lintner/Mossin
CAPM (Holthausen and Zmijewski, 2014) of the form:

RJ;t ¼ RF þ b J RM;t RF þ eJ;t (33)
where RJ,t is the rate of return for cash flow J for time t, RF is the risk-free rate of return, b J is
the measure of sensitivity for the rate of return for cash flow J, RM,t is the rate of return for
the market at time t and eJ,t is an error term for the rate of return for cash flow J. Merton
(1973a, 1973b) derived a single-factor capital asset pricing model in continuous time when
returns are distributed lognormally and the risk-free rate is deterministic. This model is the
same as the standard single-factor capital asset pricing model except that instantaneous
rates of return have replaced discrete rates of return and the distribution of rates of return is
lognormal instead of normal.
When the single-factor model is used for rates of return, the expected rate of return are
given by:

E RJ ¼ RF þ b J ½EðRM Þ RF (34)
where E(RJ) is the expected rate of return for cash flow J and E(RM) is the expected rate of
return for the market. The variances are:

s 2 RJ ¼ b 2J s 2 ðRM Þ þ s 2 ðeJ Þ (35)

where s 2 RJ is the variance for the rate of return for cash flow J, s 2 ðRM Þ is the variance
for the rate of return for the market and s 2 ðeJ Þ is the variance for the error term for the rate
of return for cash flow J. The coefficient of determination for the single-factor model is:
" #
s 2 ð RM Þ s 2 ð eJ Þ
r J;M ¼ b J
2 2 ¼ 1 (36)
s 2 RJ s 2 RJ
where r 2J;M is the coefficient of determination and b 2J is the squared sensitivity measure. Terminal
The coefficient of determination measures the portion of the variation of the rate of return values for
for cash flow J that is explained by the rate of return for the market portfolio. The portion of
the variation of the rate of return for cash flow J that is not explained by the rate of return for
firms
the market portfolio is:
s 2 ðeJ Þ
1 r 2J;M ¼ (37) 255
s 2 RJ
Taking the square root indicates the ratio of the standard deviation of the error for the rate
of return for cash flow J to the standard deviation of the rate of return for the market is also a
measure of the variation of the rate of return for cash flow J explained by the rate of return
for the market portfolio:
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi s ðeJ Þ
1 r 2J;M ¼ (38)
s RJ
The sensitivity measure for the rate of return for cash flow J with respect to the rate of return
for the market is given by:
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
" ffi
u # " #
u s 2 R s RJ
bJ ¼ t r J;M
2 J
¼ r J;M (39)
s ð RM Þ
2 s ðRM Þ
where r J,M is the correlation

between the rate of return for cash flow J and the rate of return
for the market, s RJ is the standard deviation of the rate of return for cash flow J and
s ðRM Þ is the standard deviation of the rate of return for the market. This indicates that the
correlation, a measure of sensitivity for cash flow J, the standard deviation of the rate of
return for cash flow J and the standard deviation of the rate of return for the market are
related to in the following way:
" #
s ð RM Þ
r J;M ¼ b J (40)
s RJ
The covariance for the rates of return for cash flows for J and K is:

s RJ ; RK ¼ b J b K s 2 ðRM Þ þ s ðeJ ; eK Þ (41)

where s RJ ; RK is the covariance for the rates of return for cash flows J and K and
s ðeJ ; eK Þ is covariance for the error terms for the rates of return for cash flows J and K. Cash
flow J may be the cash flow for VGO and cash flow K may be the cash flow for VIC. Since the
measures of sensitivity are:
" #
s RJ
b J ¼ r J;M (42)
s ðRM Þ

SEF s ðRK Þ
b K ¼ r K;M (43)
35,2 s ðRM Þ
and:

s RJ ; RK ¼ r J;M r K;M s RJ s ðRK Þ þ s ðeJ ; eK Þ (44)
256
The correlation between the rates of return for the cash flows for J and K is produced by
dividing the covariance by the product of the two standard deviations:
" #
s ðeJ Þ s ðeK Þ
r RJ ; RK ¼ r J;M r K;M þ r ðeJ ; eK Þ (45)
s RJ s ðRK Þ
where r (RJ, RK) is the correlation between the rates of return for cash flows J and K and r (eJ,
eK) is the correlation between the error terms for the rates of return for cash flows J and K.
The ratio of the standard deviation of the error for cash flow J to the standard deviation of
the rate of return for cash flow J is a measure of the portion of the variation of the rate of
return for cash flow J that is not explained by the rate of return for the market. The ratio
of the standard deviation of the error for cash flow K to the standard deviation of the rate of
return for cash flow K is a measure of the portion of the variation of the rate of return for
cash flow J that is not explained by the rate of return for the market. Using these
relationships indicates that the correlation between the rates of returns for cash flows J and
K is given by:
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
r RJ ; RK ¼ r J;M r K;M þ r ðeJ ; eK Þ 1 r 2J;M 1 r 2K;M (46)
In this study, possible values for the correlation between the rates of return for the cash
flows for the value of growth opportunities and the value of the invested capital required by
the growth opportunities are constrained by this equation. Possible values for the
correlation depend on the correlations of the rates of return with the rate of return on the
market portfolio and the correlation of the idiosyncratic rates of return for the two cash
flows.
4.3 An illustrative numerical example

Previous research has shown that, when an explicit forecast period of eight years is used for
a two-stage valuation model, terminal value accounts for a substantial portion of the total
value of many companies in various industries (Koller et al., 2015). Previous valuation
models for continuing value have treated the growth opportunities occurring during the
continuing value period as an obligation and not as an option. This implicitly assumes that
the company has already decided to make the required investments. As the right to wait to
make the decision about making the investments required by the growth opportunities is
valuable, previous valuation models tend to underestimate the value of growth
opportunities occurring during the continuing value period. Growth options are identified
within the structural relationships for the company during the continuing value period. An
explicit valuation model for growth options can be incorporated in the terminal value model
for the second stage of the two-stage valuation model. This terminal value model is designed
to capture the incremental value of the optionality of the growth opportunities available to
the company during the continuing value period. The resulting model for terminal value Terminal
that incorporates growth options is used to examine the magnitude of the value produced values for
during the continuing value period and compare this value to value produced during the
continuing value period when the constant growth model is used for the terminal value.
firms
An illustrative numerical example is used to examine the terminal values when the
optionality of the growth opportunities is recognized relative to the terminal values when
the optionality of the growth opportunities is not recognized. The company is assumed to be
an all-equity firm. The explicit forecast period is assumed to be 8 years. The book value of 257
capital at the end of the explicit forecast period is assumed to be 214.36. The growth rate for
the continuing value period is assumed to be 5 per cent. For all of the alternatives examined,
the annual risk-free rate is assumed to be 5 per cent, the annual rate of return for the market
portfolio is assumed to be 10 per cent, the beta for the rate of return for each cash flow is
assumed to be 1.0, the cost of capital for each cash flow is 10 per cent, the standard deviation
for the annual rate of return for the market portfolio is assumed to be 20 per cent and the
standard deviation for the annual rate of return for each cash flow is assumed to be 40 per
cent. Given these assumptions, the correlation between the rates of return for the value of the
growth opportunities and the value of the invested capital required by the growth
opportunities may be as low as 0.5 when the correlation for errors in the single-factor
model for the rates of return for the value of the growth opportunities and the value of the
invested capital required by the growth opportunities is 1.0. Given these assumptions,
the correlation between the rates of return for the value of the growth opportunities and the
value of the invested capital required by the growth opportunities may be as high as 1.0
when the correlation for errors in the single-factor model for the rates of return for the value
of the growth opportunities and the value of the invested capital required by the growth
opportunities is 1.0. Results for correlations of 0.5, 0.25, 0.0, 0.25, 0.50, 0.75 and 1.0 are
produced and examined.
Terminal values for three different situations are examined. For all three situations, the
company is assumed to have no competitive advantage or disadvantage for its existing
operations. This means that the return on capital for existing operations is 10 per cent. For
one situation, the company is assumed to have no competitive advantage or disadvantage
for growth opportunities. This implies that the return on capital for growth opportunities is
10 per cent. Table I shows the terminal values for a company that has no competitive
advantage or disadvantage for existing operations and has no competitive advantage or
disadvantage for growth opportunities for given values of the cost of capital, book value of
capital, return on capital for existing operations, growth rate, return on capital for growth
opportunities, standard deviations and correlations. For another situation, the company is
assumed to have a substantial competitive advantage for growth opportunities. In this
situation, the return on capital for growth opportunities is assumed to be 12 per cent.
Table II shows the terminal values for a company that has no competitive advantage or
disadvantage for existing operations and has a substantial competitive advantage for
growth opportunities for given values of the cost of capital, book value of capital, return on
capital for existing operations, growth rate, return on capital for growth opportunities,
standard deviations and correlations. For the other situation, the company is assumed to
have a substantial competitive disadvantage for growth opportunities. In this situation, the
return on capital for growth opportunities is assumed to be 8 per cent. Table III shows the
terminal values for a company that has no competitive advantage or disadvantage for
existing operations and has a substantial competitive disadvantage for growth
opportunities for given values of the cost of capital, book value of capital, return on capital
for existing operations, growth rate, return on capital for growth opportunities, standard
SEF R 0.10 0.10 0.10 0.10 0.10 0.10 0.10
35,2 BVCT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
ROCOP 0.10 0.10 0.10 0.10 0.10 0.10 0.10
NOPATTþ1 21.44 21.44 21.44 21.44 21.44 21.44 21.44
VOPT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VOP0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
g 0.05 0.05 0.05 0.05 0.05 0.05 0.05
258 g · NOPATTþ1 1.07 1.07 1.07 1.07 1.07 1.07 1.07
ROCGO 0.10 0.10 0.10 0.10 0.10 0.10 0.10
NINVTþ1 10.72 10.72 10.72 10.72 10.72 10.72 10.72
FCFTþ1 10.72 10.72 10.72 10.72 10.72 10.72 10.72
TVT = FCFTþ1/(Rg) 214.36 214.36 214.36 214.36 214.36 214.36 214.36w
VGOT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VICT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
NPVGOT 0.00 0.00 0.00 0.00 0.00 0.00 0.00
NPVGO0 0.00 0.00 0.00 0.00 0.00 0.00 0.00
T 8.00 8.00 8.00 8.00 8.00 8.00 8.00
VGO0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
VIC0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
d GO 0.00 0.00 0.00 0.00 0.00 0.00 0.00
d IC 0.00 0.00 0.00 0.00 0.00 0.00 0.00
s GO 0.40 0.40 0.40 0.40 0.40 0.40 0.40
s IC 0.40 0.40 0.40 0.40 0.40 0.40 0.40
r 0.50 0.25 0.00 0.25 0.50 0.75 1.00
s 0.69 0.63 0.57 0.49 0.40 0.28 0.00
E0 67.28 62.89 57.63 51.16 42.84 31.08 0.00
TV0 = TVT/(1 þ R)T 100.00 100.00 100.00 100.00 100.00 100.00 100.00
TV0 = VOP0 þ E0 167.28 162.89 157.63 151.16 142.84 131.08 100.00
Ratio without CA or CD 1.673 1.629 1.576 1.512 1.428 1.311 1.000
Notes: This table shows the terminal values for a company that has no competitive advantage or
disadvantage for existing operations and has no competitive advantage or disadvantage for growth
opportunities for given values of the cost of capital, book value of capital, return on capital for existing
operations, growth rate, return on capital for growth opportunities, standard deviations and correlation.
When the optionality of the growth opportunities is ignored, the terminal value is given by TV0 = TVT/(1 þ
R)T = [FCFTþ1/(Rg)]/(1 þ R)T. When the optionality of the growth opportunities is recognized, the
terminal value is given by TV0 = VOP0 þ E0. When the correlation is less than one, the terminal value that
incorporates the optionality of the growth opportunities is greater than the terminal value that does not
Table I.
incorporates the optionality of the growth opportunities. The size of the difference can be substantial and
Terminal values grows as the correlation decreases. Ratio without CA or CD measures the terminal values when the
without competitive optionality of the growth opportunities is recognized relative to the terminal values when the optionality of
advantages or the growth opportunities is not recognized and the company has no competitive advantage or disadvantage
disadvantages for existing operations and has no competitive advantage or disadvantage for growth opportunities
deviations and correlations. When the optionality of the growth opportunities is ignored, the
terminal value is given by TV0 = [FCFTþ1/(R – g)]/(1 þ R)T = VOP0 þ NPVGO0. When the
optionality of the growth opportunities is recognized, the terminal value is given by TV0 =
VOP0 þ E0. For all three situations, when the correlation between the rates of return for the
value of the growth opportunities and the value of the invested capital required by the
growth opportunities is less than one, the terminal value that incorporates the optionality of
the growth opportunities is greater than the terminal value that does not incorporates the
optionality of the growth opportunities. For all three situations, the size of the difference can
be substantial and grows as the correlation decreases. The ratio of (VOP0 þ E0) to [FCFTþ1/
R 0.10 0.10 0.10 0.10 0.10 0.10 0.10
Terminal
BVCT 214.36 214.36 214.36 214.36 214.36 214.36 214.36 values for
ROCOP 0.10 0.10 0.10 0.10 0.10 0.10 0.10 firms
NOPATTþ1 21.44 21.44 21.44 21.44 21.44 21.44 21.44
VOPT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VOP0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
G 0.05 0.05 0.05 0.05 0.05 0.05 0.05
g · NOPATTþ1 1.07 1.07 1.07 1.07 1.07 1.07 1.07 259
ROCGO 0.12 0.12 0.12 0.12 0.12 0.12 0.12
NINVTþ1 8.93 8.93 8.93 8.93 8.93 8.93 8.93
FCFTþ1 12.50 12.50 12.50 12.50 12.50 12.50 12.50
TVT=FCFTþ1/(Rg) 250.09 250.09 250.09 250.09 250.09 250.09 250.09
VGOT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VICT 178.63 178.63 178.63 178.63 178.63 178.63 178.63
NPVGOT 35.73 35.73 35.73 35.73 35.73 35.73 35.73
NPVGO0 16.67 16.67 16.67 16.67 16.67 16.67 16.67
T 8.00 8.00 8.00 8.00 8.00 8.00 8.00
VGO0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
VIC0 83.33 83.33 83.33 83.33 83.33 83.33 83.33
d GO 0.00 0.00 0.00 0.00 0.00 0.00 0.00
d IC 0.00 0.00 0.00 0.00 0.00 0.00 0.00
s GO 0.40 0.40 0.40 0.40 0.40 0.40 0.40
s IC 0.40 0.40 0.40 0.40 0.40 0.40 0.40
r 0.50 0.25 0.00 0.25 0.50 0.75 1.00
s 0.69 0.63 0.57 0.49 0.40 0.28 0.00
E0 70.20 66.21 61.43 55.57 48.06 37.52 16.67
TV0 = TVT/(1 þ R)T 116.67 116.67 116.67 116.67 116.67 116.67 116.67
TV0 = VOP0 þ E0 170.20 166.21 161.43 155.57 148.06 137.52 116.67
Ratio with CA 1.459 1.425 1.384 1.333 1.269 1.179 1.000
disadvantage for existing operations and has a substantial competitive advantage for growth opportunities
for given values of the cost of capital, book value of capital, return on capital for existing operations, growth
rate, return on capital for growth opportunities, standard deviations and correlation. When the optionality
of the growth opportunities is ignored, the terminal value is given by TV0 = TVT/(1 þ R)T = [FCFTþ1/
(Rg)]/(1 þ R)T. When the optionality of the growth opportunities is recognized, the terminal value is given
by TV0 = VOP0 þ E0. When the correlation is less than one, the terminal value that incorporates
the optionality of the growth opportunities is greater than the terminal value that does not incorporates the
optionality of the growth opportunities. The size of the difference can be substantial and grows as the
correlation decreases. Ratio with CA measures the terminal values when the optionality of the growth Table II.
opportunities is recognized relative to the terminal values when the optionality of the growth opportunities Terminal values with
is not recognized and the company has no competitive advantage or disadvantage for existing operations a competitive
and has a substantial competitive advantage for growth opportunities advantage
(R – g)]/(1 þ R)T is always greater than or equal to 1.0, is largest when the company has a
substantial competitive disadvantage for growth opportunities and is smallest when the
company has a substantial competitive advantage for growth opportunities. This result is
reasonable because implicitly assuming that the company has already decided to make the
required investments when company has a competitive disadvantage for growth
opportunities means the company has decided to invest in an opportunity that has a
negative net present value.
Table I shows the ratio of the terminal values when the optionality of the growth
opportunities is recognized relative to the terminal values when the optionality of the
SEF R 0.10 0.10 0.10 0.10 0.10 0.10 0.10
35,2 BVCT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
ROCOP 0.10 0.10 0.10 0.10 0.10 0.10 0.10
NOPATTþ1 21.44 21.44 21.44 21.44 21.44 21.44 21.44
VOPT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VOP0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
g 0.05 0.05 0.05 0.05 0.05 0.05 0.05
260 g · NOPATTþ1 1.07 1.07 1.07 1.07 1.07 1.07 1.07
ROCGO 0.08 0.08 0.08 0.08 0.08 0.08 0.08
NINVTþ1 13.40 13.40 13.40 13.40 13.40 13.40 13.40
FCFTþ1 8.04 8.04 8.04 8.04 8.04 8.04 8.04
TVT = FCFTþ1/(Rg) 160.77 160.77 160.77 160.77 160.77 160.77 160.77
VGOT 214.36 214.36 214.36 214.36 214.36 214.36 214.36
VICT 267.95 267.95 267.95 267.95 267.95 267.95 267.95
NPVGOT 53.59 53.59 53.59 53.59 53.59 53.59 53.59
NPVGO0 25.00 25.00 25.00 25.00 25.00 25.00 25.00
T 8.00 8.00 8.00 8.00 8.00 8.00 8.00
VGO0 100.00 100.00 100.00 100.00 100.00 100.00 100.00
VIC0 125.00 125.00 125.00 125.00 125.00 125.00 125.00
d GO 0.00 0.00 0.00 0.00 0.00 0.00 0.00
d IC 0.00 0.00 0.00 0.00 0.00 0.00 0.00
s GO 0.40 0.40 0.40 0.40 0.40 0.40 0.40
s IC 0.40 0.40 0.40 0.40 0.40 0.40 0.40
r 0.50 0.25 0.00 0.25 0.50 0.75 1.00
s 0.69 0.63 0.57 0.49 0.40 0.28 0.00
E0 63.54 58.67 52.84 45.68 36.53 23.74 0.00
TV0 = TVT/(1 þ R)T 75.00 75.00 75.00 75.00 75.00 75.00 75.00
TV0 = VOP0 þ E0 163.54 158.67 152.84 145.68 136.53 123.74 100.00
Ratio with CD 2.181 2.116 2.038 1.942 1.820 1.650 1.333
disadvantage for existing operations and has a substantial competitive disadvantage for growth
opportunities for given values of the cost of capital, book value of capital, return on capital for existing
operations, growth rate, return on capital for growth opportunities, standard deviations and correlation.
When the optionality of the growth opportunities is ignored, the terminal value is given by TV0 = TVT/(1 þ
R)T = [FCFTþ1/(Rg)]/(1 þ R)T. When the optionality of the growth opportunities is recognized, the
terminal value is given by TV0 = VOP0 þ E0. The terminal value that incorporates the optionality of
the growth opportunities is greater than the terminal value that does not incorporates the optionality of the
growth opportunities. The size of the difference can be substantial and grows as the correlation decreases.
Table III. Ratio with CD measures the terminal values when the optionality of the growth opportunities is recognized
Terminal values with relative to the terminal values when the optionality of the growth opportunities is not recognized and the
a competitive company has a substantial competitive disadvantage for growth opportunities; italics are used to highlight
disadvantage the correlation row in the table
growth opportunities is not recognized ranges from 1.0 to 1.673 when the company has no
competitive advantage or disadvantage for existing operations and has no competitive
advantage or disadvantage for growth opportunities. Table II shows the ratio of the
terminal values when the optionality of the growth opportunities is recognized relative to
the terminal values when the optionality of the growth opportunities is not recognized
ranges from 1.0 to 1.459 when the company has no competitive advantage or disadvantage
for existing operations and has a substantial competitive advantage for growth
opportunities. Table III shows the ratio of the terminal values when the optionality of the
growth opportunities is recognized relative to the terminal values when the optionality of
the growth opportunities is not recognized ranges from 1.333 to 2.181 when the company
has no competitive advantage or disadvantage for existing operations and has a substantial Terminal
competitive disadvantage for growth opportunities. values for
Figure 1 summarizes the results for the relative importance of the optionality of growth
opportunities for correlations between the rates of return for the value of the growth
firms
opportunities and the value of the invested capital required by the growth opportunities of
0.5, 0.25, 0.0, 0.25, 0.50, 0.75 and 1.0. The dashed line (labeled Ratio without CA or CD)
which is for information in Table I shows the ratio of the terminal values when the
optionality of the growth opportunities is recognized relative to the terminal values when 261
the optionality of the growth opportunities is not recognized when the company has no
competitive advantage or disadvantage for existing operations and has no competitive
advantage or disadvantage for growth opportunities. The dotted line (labeled Ratio with
CA) which is for information in Table II shows the ratio of the terminal values when the
competitive advantage or disadvantage for existing operations and has a substantial
competitive advantage for growth opportunities. The solid line (labeled Ratio with CD)
which is for information in Table III shows the ratio of the terminal values when the
Ratio of (VOP0 + E 0) to {[FCFT + 1 /(R-g)]/(1 + R) T}
Correlation between Rates of Return for VGO and VIC
Figure 1.
Relative importance
of the optionality of
Ratio with CA Ratio without CA or CD Ratio with CD growth opportunities
SEF competitive advantage or disadvantage for existing operations and has a substantial
35,2 competitive disadvantage or disadvantage for growth opportunities.
Valuation models for terminal value that treat the growth opportunities occurring during
the continuing value period as an obligation and not as an option (implicitly assuming that
the company has already decided to make the required investments) can underestimate the
value of growth opportunities occurring during the continuing value period by substantial
262 amounts because the right to wait to make the decision about making the investments
required by the growth opportunities is often very valuable. When the correlation between
the rates of return for the value of the growth opportunities and the value of the invested
capital required by the growth opportunities is 0.50, the ratio of the terminal values when
the optionality of the growth opportunities is recognized relative to the terminal values
when the optionality of the growth opportunities is not recognized is the largest. When the
correlation between the rates of return for the value of the growth opportunities and
the value of the invested capital required by the growth opportunities is 1.0, the ratio of the
terminal values when the optionality of the growth opportunities is recognized relative to
the terminal values when the optionality of the growth opportunities is not recognized is the
smallest.
5. An explanation for IPO price behavior

Many studies have examined the pricing of common stock of companies that have had an
initial public offering (Brav and Gompers, 1997; Cornelli et al., 2006; Fisher and McDonald,
1972; Hoberg, 2007; Logue, 1973; Loughran and Ritter, 1995; Lowry and Schwert, 2002;
Ritter, 2003; Ritter and Welch, 2002; Shaw, 1971; and Wagner, 2004). Ritter and Welch (2002)
provide information on IPO companies in the USA. The most common way to value
companies going public and establish offer prices is to use multiples of comparable seasoned
companies. However, many companies going public are small risky firms being valued in
the financial markets on the basis of growth options, not financial statements. In addition,
shares of many IPO companies are difficult to sell short in the after-market. The shares of
companies going public in the US trade at about 19 per cent on average more than the price
at which they were sold. Over the first three years, IPO companies underperform the value-
weighted market portfolio by about 23.5 per cent on average and underperform comparable
seasoned companies by about 5 per cent on average. The three-year average market-
adjusted buy-and-hold returns for IPO companies in the USA are negative. There are
variations in these general patterns because of time periods, style categories, sample
selection criteria, measurement issues, factor contamination biases and econometric
methodologies used. Wagner (2004) presents a market model that incorporates time-varying
idiosyncratic risk and uses it to provide information on conditional abnormal returns by
applying it to initial public offering (IPO) aftermarket stock returns. A positive relationship
between stock returns and idiosyncratic risk for IPO companies is found and is consistent
with the idea that the equity of these firms is a contingent claim on the underlying assets.
Increases in the volatility of the value of the underlying assets increases the value of a call
option, the stock and also increases the stock’s volatility. Skewness of aftermarket returns is
found and is consistent with the idea that returns are generated by a mixture of distributions
over time. Conditioning on idiosyncratic risk is found to reduce the statistical significance of
abnormal returns in the IPO aftermarket when compared to abnormal returns produced by
the standard approach.
Terminal value models for two-stage valuation models that do not recognize the
optionality of the growth opportunities available to the firm and do recognize the optionality
of the growth opportunities available to the firm generate price behavior for firms that have
initial public offerings which is consistent with the findings of the empirical studies. Terminal
Assume that the initial public offering price is based on a two-stage valuation model that values for
does not recognize the optionality of the growth opportunities occurring during the
continuing value period. Also, assume that subsequent market prices are based on a two-
firms
stage valuation model that does recognize the optionality of the growth opportunities
occurring during the continuing value period. Assume the company is an all-equity firm that
has no competitive advantage or disadvantage during the explicit forecast period. As in the
previous section, for all of the alternatives examined for this company, the annual risk-free 263
rate is assumed to be 5 per cent, the annual rate of return for the market portfolio is assumed
to be 10 per cent, the beta for the rate of return for each cash flow is assumed to be 1.0, the
cost of capital for each cash flow is 10 per cent, the standard deviation for the annual rate of
return for the market portfolio is assumed to be 20 per cent and the standard deviation for
the annual rate of return for each cash flow is assumed to be 40 per cent. Given these
assumptions, the correlation between the rates of return for the value of the growth
opportunities and the value of the invested capital required by the growth opportunities
may be as low as 0.5 and may be as high as 1.0. Results for correlations of 0.5, 0.25, 0.0,
0.25, 0.50, 0.75 and 1.0 are again produced and examined. The explicit forecast period is
assumed to be 8 years. The initial public offering occurs at the beginning of the explicit
forecast period. The book value of capital at the beginning of the explicit forecast period is
assumed to be 100. The growth rate of the company’s book value of capital during each year
of the explicit forecast period is assumed to be 10 per cent. The book value of capital at the
end of the explicit forecast period will be 214.36. As the company has no competitive
advantage or competitive disadvantage during the explicit forecast period, the return on
capital will be equal to the cost of capital which is 10 per cent. As the return on capital is 10
per cent, the net operating profit after taxes in each year will equal 10 per cent of the book
value of capital at the beginning of the year. As the growth rate is 10 per cent the net
investment in each year will also equal 10 per cent of the book value of capital at the
beginning of the year. This means that the free cash flow will equal zero in each year of the
explicit forecast period and the value of the company will equal TV0.
Again, terminal values for the continuing value period are examined for three different
situations. For one situation, the company is assumed to have no competitive advantage or
disadvantage for growth opportunities. This implies that the return on capital for growth
opportunities is 10 per cent. For another situation, the company is assumed to have a
substantial competitive advantage for growth opportunities. In this situation, the return on
capital for growth opportunities is assumed to be 12 per cent. For the other situation, the
company is assumed to have a substantial competitive disadvantage for growth opportunities.
In this situation, the return on capital for growth opportunities is assumed to be 8 per cent.
Tables IV to VI show values of the company and abnormal rates of return when the
company has no competitive advantage or disadvantage for existing operations and the
optionality of the growth opportunities is recognized for given values of the cost of capital,
book value of capital, return on capital for existing operations, growth rate, return on capital
for growth opportunities, standard deviations and correlation. When the optionality of the
growth opportunities is recognized, the value of the company is given by TV0 = VOP0 þ E0.
When the correlation between the rates of return for the value of growth opportunities and
the value of the invested capital required by the growth opportunities is less than one and
the number of years left in the explicit forecast period is greater than zero, the value of the
company that incorporates the optionality of the growth opportunities is greater than the
value of the company that does not incorporates the optionality of the growth opportunities.
The size of the difference can be substantial and grows as the correlation decreases. Values
SEF Years Correlation between rates of return for VGO and VIC
35,2 Passed Left 0.5 0.25 0.00 0.25 0.50 0.75 1.00
Panel A. Values of the company during the explicit forecast period

0 8 167.28 162.89 157.63 151.16 142.84 131.08 100.00
1 7 180.47 175.69 170.03 163.14 154.36 142.09 110.00
2 6 194.07 188.93 182.90 175.63 166.47 153.79 121.00
264 3 5 207.83 202.38 196.04 188.49 179.06 166.13 133.10
4 4 221.31 215.65 209.13 201.43 191.92 179.02 146.41
5 3 233.76 228.07 221.57 213.98 204.69 192.22 161.05
6 2 243.73 238.32 232.22 225.16 216.61 205.24 177.16
7 1 247.68 243.23 238.27 232.58 225.76 216.79 194.87
8 0 214.36 214.36 214.36 214.36 214.36 214.36 214.36
Panel B. Percentage abnormal rates of return during the explicit forecast period
Year
0 67.28 62.89 57.63 51.16 42.84 31.08 0.00
1 2.12 2.14 2.13 2.08 1.93 1.60 0.00
2 2.46 2.47 2.43 2.34 2.16 1.77 0.00
3 2.91 2.88 2.81 2.68 2.44 1.97 0.00
4 3.51 3.44 3.32 3.13 2.82 2.24 0.00
5 4.37 4.24 4.05 3.77 3.35 2.63 0.00
6 5.74 5.50 5.19 4.77 4.18 3.22 0.00
7 8.38 7.94 7.40 6.70 5.77 4.37 0.00
8 23.45 21.87 20.04 17.83 15.05 11.12 0.00
Notes: This table shows values of the company and abnormal rates of return when the company has no
competitive advantage or disadvantage for existing operations and has no competitive advantage or
Table IV. disadvantage for growth opportunities and the optionality of the growth opportunities is recognized for
Values of the given values of the cost of capital, book value of capital, return on capital for existing operations, growth
company and market rate, return on capital for growth opportunities, standard deviations and correlation. When the optionality
rates of return of the growth opportunities is recognized, the value of the company is given by TV0 = VOP0 þ E0. When
without competitive the correlation is less than one and the number of years left in the explicit forecast period is greater than
zero, the value of the company that incorporates the optionality of the growth opportunities is greater than
advantages or
the value of the company that does not incorporates the optionality of the growth opportunities. The size of
disadvantages when the difference can be substantial and grows as the correlation decreases. Values of the company are shown
the optionality of after zero, one, two, three, four, five, six, seven, and eight years have passed. Abnormal rates of return are
growth opportunities shown for Years 0, 1, 2, 3, 4, 5, 6, 7 and 8 after the initial public offering. The abnormal rate of return shown
is recognized for Year 0 is the first-day rate of return
of the company when the optionality of the growth opportunities is recognized are shown for
t years after the initial public offering where t = 0, 1, . . ., 8 indicates the number of years that
have passed since the initial public offering. The values of the company when the
optionality of the growth opportunities is recognized after t years have passed are given by
TVt = VOPt þ Et. Abnormal rates of return are shown for t years after the initial public
offering. The abnormal rates of return shown for year 0 are the first-day abnormal rates of
return for the initial public offering. First-day abnormal rates of return for the initial public
offering are given by:
VOP0 þ E0
AR0 ¼ T
1 (47)
FCFTþ1 =ðR gÞ =ð1 þ RÞ
where AR0 is the first-day abnormal rate of return and T is eight years. Subsequent Terminal
abnormal rates of return for the initial public offering are given by: values for
VOPt þ Et firms
ARt ¼ 1 (48)
VOPt þ Et1
where ARt is the abnormal rate of return for year t and t = 1, 2, . . ., 8 indicates the number of
years that have passed since the initial public offering.
265
Table IV shows values of the company and abnormal rates of return when the company
has no competitive advantage or disadvantage for existing operations and has no
competitive advantage or disadvantage for growth opportunities and the optionality of the
growth opportunities is recognized for given values of the cost of capital, book value of
capital, return on capital for existing operations, growth rate, return on capital for growth
opportunities, standard deviations and correlation. Values of the company when the
optionality of the growth opportunities is recognized are shown for t years after the initial
public offering where t = 0, 1, . . ., 8 indicates the number of years that have passed since the
initial public offering. When the correlation between the rates of return for the value of
opportunities is less than one, the values of the company increase as t increases until it
reaches t = 8 when the values of the company decrease. The decrease in the values of the
company when t = 8 is because of the expiration of the growth option. When the correlation
between the rates of return for the value of growth opportunities and the value of the
invested capital required by the growth opportunities is 0.50, the value of the company
grows from 167.28 when t = 0 to 247.68 when t = 7 and decreases to 214.36 when t = 8.
the value of the invested capital required by the growth opportunities is 0.75, the value of the
company grows from 131.08 when t = 0 to 216.79 when t = 7 and decreases to 214.36 when
t = 8. Values of the company for other values of the correlation between the rates of return
for the value of growth opportunities and the value of the invested capital required by the
growth opportunities are shown in Table IV. Abnormal rates of return are shown for t years
after the initial public offering. The abnormal rates of return shown for year 0 are the first-
day abnormal rates of return for the initial public offering. When the correlation between the
rates of return for the value of growth opportunities and the value of the invested capital
required by the growth opportunities is less than one, the first-day abnormal rates of return
for the initial public offering are positive and sizable and increase as the correlation
decreases. When the correlation between the rates of return for the value of growth
opportunities and the value of the invested capital required by the growth opportunities is
0.50, the first-day abnormal rate of return is 67.28 per cent. When the correlation between
the rates of return for the value of growth opportunities and the value of the invested capital
required by the growth opportunities is 0.75, the first-day abnormal rate of return is 31.08
per cent. First-day abnormal rates of return for other values of the correlation between the
rates of return for the value of growth opportunities and the value of the invested capital
required by the growth opportunities are shown in Table IV.
Subsequent abnormal annual rates of return for t years after the initial public
offering are negative and sizable and decrease as the correlation decreases and decrease
as the number of years that have passed since the initial public offering increases.
When the correlation between the rates of return for the value of growth opportunities
and the value of the invested capital required by the growth opportunities is 0.50, the
abnormal annual rate of return declines from 2.12 per cent when t = 1 to 8.38
SEF per cent when t = 7 and decreases to 23.45 per cent when t = 8. When the correlation
35,2 between the rates of return for the value of growth opportunities and the value of the invested
capital required by the growth opportunities is 0.75, the abnormal annual rate of return
declines from 1.60 per cent when t = 1 to 4.37 per cent when t = 7 and decreases to 11.12
per cent when t = 8. Abnormal annual rates of return when t = 1, 2, . . ., 8 for other values of
the correlation between the rates of return for the value of growth opportunities and
266 the value of the invested capital required by the growth opportunities are shown in
Table IV.
Table V shows values of the company and abnormal rates of return when the company
has no competitive advantage or disadvantage for existing operations and a substantial
competitive advantage for growth opportunities and the optionality of the growth
opportunities is recognized for given values of the cost of capital, book value of capital,
Years Correlation between rates of return for VGO and VIC

Passed Left 0.50 0.25 0.00 0.25 0.50 0.75 1.00

0 8 170.20 166.21 161.43 155.57 148.06 137.52 116.67
1 7 184.00 179.67 174.53 168.29 160.38 149.41 128.33
2 6 198.36 193.70 188.24 181.67 173.43 162.13 141.17
3 5 213.07 208.14 202.41 195.59 187.13 175.67 155.28
4 4 227.77 222.65 216.77 209.85 201.35 189.99 170.81
5 3 241.80 236.67 230.83 224.03 215.79 204.95 187.89
6 2 253.91 249.07 243.63 237.37 229.89 220.25 206.68
7 1 261.11 257.21 252.88 247.99 242.27 235.19 227.35
8 0 250.09 250.09 250.09 250.09 250.09 250.09 250.09
Year
0 45.88 42.47 38.37 33.35 26.91 17.88 0.00
1 1.89 1.90 1.89 1.82 1.68 1.36 0.00
2 2.19 2.19 2.14 2.05 1.86 1.49 0.00
3 2.58 2.55 2.47 2.34 2.10 1.64 0.00
4 3.10 3.03 2.91 2.71 2.40 1.85 0.00
5 3.84 3.71 3.51 3.24 2.83 2.13 0.00
6 4.99 4.76 4.45 4.05 3.47 2.54 0.00
7 7.17 6.73 6.20 5.53 4.61 3.21 0.00
8 14.22 12.77 11.11 9.15 6.77 3.67 0.00
competitive advantage or disadvantage for existing operations and has a substantial competitive
Table V. advantage for growth opportunities and the optionality of the growth opportunities is recognized for given
Values of the values of the cost of capital, book value of capital, return on capital for existing operations, growth rate,
company and market return on capital for growth opportunities, standard deviations and correlation. When the optionality of the
rates of return with a growth opportunities is recognized, the value of the company is given by TV0 = VOP0 þ E0. When the
substantial correlation is less than one and the number of years left in the explicit forecast period is greater than zero,
the value of the company that incorporates the optionality of the growth opportunities is greater than the
competitive
value of the company that does not incorporates the optionality of the growth opportunities. The size of the
advantage when the difference can be substantial and grows as the correlation decreases. Values of the company are shown after
optionality of growth zero, one, two, three, four, five, six, seven, and eight years have passed. Abnormal rates of return are shown
opportunities is for Years 0, 1, 2, 3, 4, 5, 6, 7 and 8 after the initial public offering. The abnormal rate of return shown for
recognized year 0 is the first-day rate of return
return on capital for existing operations, growth rate, return on capital for growth Terminal
opportunities, standard deviations and correlation. Values of the company when the values for
firms
opportunities is less than one, the values of the company increase as t increases until it
reaches t = 8 when the values of the company decrease. The decrease in the values of the 267
company when t = 8 is because of the expiration of the growth. When the correlation
invested capital required by the growth opportunities is 0.50, the value of the company
the value of the invested capital required by the growth opportunities is 0.75, the value of the
company grows from 137.52 when t = 0 to 250.09 when t = 8. Values of the company for
other values of the correlation between the rates of return for the value of growth
opportunities and the value of the invested capital required by the growth opportunities are
shown in Table V.
Abnormal rates of return are shown for t years after the initial public offering. The
abnormal rates of return shown for year 0 are the first-day abnormal rates of return for the
opportunities is less than one, the first-day abnormal rates of return for the initial public
offering are positive and sizable and increase as the correlation decreases. When the
correlation between the rates of return for the value of growth opportunities and the value of
the invested capital required by the growth opportunities is 0.50, the first-day abnormal
rate of return is 45.88 per cent. When the correlation between the rates of return for the value
of growth opportunities and the value of the invested capital required by the growth
opportunities is 0.75, the first-day abnormal rate of return is 17.88 per cent. First-day
abnormal rates of return for other values of the correlation between the rates of return for
the value of growth opportunities and the value of the invested capital required by the
growth opportunities are shown in Table V.
Subsequent abnormal annual rates of return for t years after the initial public
offering are negative and sizable and decrease as the correlation decreases and decrease
as the number of years that have passed since the initial public offering increases.
When the correlation between the rates of return for the value of growth opportunities
and the value of the invested capital required by the growth opportunities is 0.50, the
abnormal rate of return declines from 1.89 per cent when t = 1 to 7.17 per cent when
t = 7 and decreases to 14.22 per cent when t = 8. When the correlation between the
rates of return for the value of growth opportunities and the value of the invested
capital required by the growth opportunities is 0.75, the abnormal rate of return
declines from 1.36 per cent when t = 1 to 3.21 per cent when t = 7 and decreases to
3.67 per cent when t = 8. Abnormal annual rates of return when t = 1, 2, . . ., 8 for other
values of the correlation between the rates of return for the value of growth
opportunities and the value of the invested capital required by the growth opportunities
are shown in Table V.
Table VI shows values of the company and abnormal rates of return when the company
has no competitive advantage or disadvantage for existing operations and a substantial
competitive disadvantage for growth opportunities and the optionality of the growth
SEF Years Correlation between rates of return for VGO and VIC
35,2 Passed Left 0.50 0.25 0.00 0.25 0.50 0.75 1.00

0 8 163.54 158.67 152.84 145.68 136.53 123.74 100.00
1 7 175.96 170.67 164.40 156.79 147.16 133.86 110.00
2 6 188.63 182.94 176.28 168.27 158.24 144.57 121.00
268 3 5 201.23 195.21 188.23 179.93 169.65 155.83 133.10
4 4 213.29 207.05 199.89 191.47 181.17 167.52 146.41
5 3 223.96 217.71 210.62 202.38 192.43 179.47 161.05
6 2 231.68 225.81 219.22 211.67 202.70 191.31 177.16
7 1 232.84 228.14 222.97 217.15 210.44 202.38 194.87
8 0 214.36 214.36 214.36 214.36 214.36 214.36 214.36
Year
0 118.06 111.56 103.78 94.24 82.04 64.99 33.33
1 2.41 2.44 2.43 2.37 2.21 1.82 0.00
2 2.80 2.81 2.78 2.68 2.47 2.00 0.00
3 3.32 3.29 3.22 3.07 2.79 2.22 0.00
4 4.01 3.94 3.80 3.58 3.21 2.50 0.00
5 5.00 4.85 4.63 4.30 3.79 2.87 0.00
6 6.55 6.28 5.92 5.41 4.66 3.40 0.00
7 9.50 8.97 8.29 7.41 6.18 4.21 0.00
8 17.94 16.04 13.86 11.29 8.14 4.08 0.00
competitive advantage or disadvantage for existing operations and has a substantial competitive
Table VI. disadvantage for growth opportunities and the optionality of the growth opportunities is recognized for
Values of the given values of the cost of capital, book value of capital, return on capital for existing operations, growth
company and market rate, return on capital for growth opportunities, standard deviations and correlation. When the optionality
rates of return with a of the growth opportunities is recognized, the value of the company is given by TV0 = VOP0 þ E0. When
substantial the correlation is less than one and the number of years left in the explicit forecast period is greater than
zero, the value of the company that incorporates the optionality of the growth opportunities is greater than
competitive
the value of the company that does not incorporates the optionality of the growth opportunities. The size of
disadvantage when the difference can be substantial and grows as the correlation decreases. Values of the company are shown
the optionality of after zero, one, two, three, four, five, six, seven and eight years have passed. Abnormal rates of return are
growth opportunities shown for Years 0, 1, 2, 3, 4, 5, 6, 7 and 8 after the initial public offering. The abnormal rate of return shown
is recognized for Year 0 is the first-day rate of return
opportunities is recognized for given values of the cost of capital, book value of capital,
return on capital for existing operations, growth rate, return on capital for growth
opportunities, standard deviations and correlation. Values of the company when the
opportunities is less than one, the value of the company increases as t increases. When the
the invested capital required by the growth opportunities is 0.50, the value of the company
the value of the invested capital required by the growth opportunities is 0.75, the value of the Terminal
company grows from 123.74 when t = 0 to 214.36 when t = 8. Values of the company for values for
other values of the correlation between the rates of return for the value of growth
opportunities and the value of the invested capital required by the growth opportunities are
firms
shown in Table VI.
Abnormal rates of return are shown for t years after the initial public offering. The
abnormal rates of return shown for year 0 are the first-day abnormal rates of return for the
initial public offering. When the correlation between the rates of return for the value of 269
opportunities is less than one, the first-day abnormal rates of return for the initial public
offering are positive and sizable and increase as the correlation decreases. When the
the invested capital required by the growth opportunities is 0.50, the first-day abnormal
rate of return is 118.06 per cent. When the correlation between the rates of return for the
value of growth opportunities and the value of the invested capital required by the growth
opportunities is 0.75, the first-day abnormal rate of return is 64.99 per cent. First-day
abnormal rates of return for other values of the correlation between the rates of return for
the value of growth opportunities and the value of the invested capital required by the
growth opportunities are shown in Table VI.
Subsequent abnormal annual rates of return for t years after the initial public offering are
negative and sizable and decrease as the correlation decreases and decrease as the number
of years that have passed since the initial public offering increases. When the correlation
invested capital required by the growth opportunities is 0.50, the abnormal annual rate of
return declines from 2.41 per cent when t = 1 to 9.50 per cent when t = 7 and decreases to
17.94 per cent when t = 8. When the correlation between the rates of return for the value of
opportunities is 0.75, the abnormal rate of return declines from 1.82 per cent when t = 1 to
4.08 per cent when t = 8. Abnormal annual rates of return when t = 1, 2, . . ., 8 for other
values of the correlation between the rates of return for the value of growth opportunities
and the value of the invested capital required by the growth opportunities are shown in
Table VI.
For a given correlation between the rates of return for the value of growth opportunities
and the value of the invested capital required by the growth opportunities, the value of the
company is the largest when the company has a substantial competitive advantage for its
growth opportunities and is smallest when the company has a substantial competitive
disadvantage for its growth opportunities. For a given correlation, the first-day abnormal
rate of return is the largest when the company has a substantial competitive disadvantage
for its growth opportunities and is the smallest when the company has a substantial
competitive advantage for its growth opportunities. For a given correlation, subsequent
abnormal rates of return are most negative when the company has a substantial competitive
disadvantage for its growth opportunities and are least negative when the company has a
substantial competitive advantage for its growth opportunities. For all types of companies,
those with a substantial competitive disadvantage for its growth opportunities, those with
no competitive advantage or disadvantage for its growth opportunities, and those with a
substantial competitive advantage for its growth opportunities, the first-day abnormal rates
of return are positive and substantial and subsequent abnormal annual rates of return are
consistently negative and decrease as the number of years since the initial public offering
increase.
SEF 6. Summary and conclusions
35,2 Many financial analysts routinely employ two-stage valuation models to estimate the value
of a company (Damodaran, 2012; Holthausen and Zmijewski, 2014; and Koller et al., 2015).
The value of a company is equal to the present value of its expected future cash flows over
the firm’s life which is assumed to be infinite. The first stage is called the explicit forecast
period. The explicit forecast period can accommodate a variety of different types of
270 performance over time. The second stage is called the continuing value period. All of the
time periods after the first stage are included in the continuing value period which is treated
as a steady state with constant stable long-term relationships. Terminal value models are
used to estimate the value of the cash flows occurring during the continuing value period.
Constant growth models with constant perpetual growth rates and constant costs of capital
are usually used to estimate terminal values (Damodaran, 2012; Fernandez, 2002;
Holthausen and Zmijewski, 2014; and Koller et al., 2015). When a two-stage value model is
used, a large portion of the value of a company usually comes from its terminal value.
This research uses fundamental models which incorporate structural relationships
within the firm in the terminal value model for the second stage of a two-stage valuation
model for a company. This analysis shows that the terminal value that is produced during
the continuing value period is equal to the value of continuing existing operations during the
continuing value period plus the value of growth opportunities during the continuing value
period minus the value of the additional invested capital required by the growth
opportunities during the continuing value period. The constant growth model assumes that
the company has an obligation to invest in the growth opportunities that are available after
the explicit forecast period. At time 0, the company has the right, but not an obligation to
invest in the growth opportunities that are available in the continuing value period. At time
0, the company owns a European exchange option on the growth opportunities occurring
during the continuing value period. Treating the growth opportunities occurring during the
continuing value period as an obligation, and not as an option, implicitly assumes that the
company has already decided to make the required investments. As the right to wait to
make the decision about making the investments required by the growth opportunities is
valuable, previous valuation models tend to underestimate the value of growth
opportunities occurring during the continuing value period. This may cause analysts to
inflate estimates of competitive advantages and long-term growth rates to compensate for
the undervaluation resulting from the misspecification the terminal value model. The
innovation in this research is that growth options are identified within the structural
relationships for the company during the continuing value period. An explicit valuation
model for growth options is introduced into the terminal value model. This model captures
the incremental value of the optionality of the growth opportunities available to the
company. The resulting model for terminal value incorporating the model for growth
options is used to examine the magnitude of the terminal value produced during the
continuing value period and compare it to the terminal value produced during the
continuing value period when a constant growth model is used.
An illustrative numerical example is used to examine the terminal values when the
the optionality of the growth opportunities is not recognized. When the correlation between
the rates of return for the value of the growth opportunities and the value of the invested
capital required by the growth opportunities is less than one, the terminal value that
incorporates the optionality of the growth opportunities is greater than the terminal value
that does not incorporates the optionality of the growth opportunities. The size of
the difference can be substantial and grows as the correlation decreases. The ratio of the
terminal when the optionality of the growth opportunities is recognized to the terminal value Terminal
when the optionality of the growth opportunities is not recognized is always greater than or values for
equal to 1.0, is largest when the company has a substantial competitive disadvantage for
growth opportunities, and is smallest when the company has a substantial competitive
firms
advantage for growth opportunities.
This research shows that valuation models for terminal value that treat the growth
opportunities occurring during the continuing value period as an obligation and not as an
option can underestimate the value of growth opportunities occurring during the continuing 271
value period by substantial amounts. The significant outcome is that a company’s terminal
value can be a large portion of the company’s total value without making unreasonable
assumptions about large competitive advantages or large steady-state growth rates that are
greater than the growth rate for the economy. The large contribution of the terminal value to
the total value of the company comes from the value of the optionality of the growth
opportunities that are available to the company in the continuing value period.
This research also shows that when the initial public offering price is based on a two-
stage valuation model that does not recognize the optionality of the growth opportunities
occurring during the continuing value period and the subsequent market prices are based on
a two-stage valuation model that does recognize the optionality of the growth opportunities
occurring during the continuing value period, the price behavior for initial public offerings is
consistent with empirical studies that have shown that on average companies that have had
an initial public offering have very large, positive first-day abnormal rates of return and
substantial negative abnormal rates of return over the subsequent three to five years.
References
Berk, J.P., Green, R.C. and Naik, V. (1999), “Optimal investment, growth options, and security returns”,
Journal of Finance, Vol. 54 No. 5, pp. 1553-1607.
Bjerksund, P. and Stensland, G. (1993), “American exchange options and a put-call transformation”,
Journal of Business Finance & Accounting, Vol. 20 No. 5, pp. 761-764.
Black, F. and Scholes, M. (1973), “The pricing of options and corporate liabilities”, Journal of Political
Economy, Vol. 81 No. 3, pp. 637-657.
Brav, A. and Gompers, P.D. (1997), “Myth or reality? The long-term underperformance of initial public
offerings: evidence from venture and nonventure capital-backed companies”, Journal of Finance,
Vol. 52 No. 5, pp. 1791-1821.
Chriss, N.A. (1997), Black-Scholes and beyond: Option Pricing Models, McGraw-Hill, New York, NY.
Cornelli, F., Goldreich, D. and Ljungqvist, A. (2006), “Investor sentiment and pre-IPO market”, The
Journal of Finance, Vol. 61 No. 3, pp. 1187-1216.
Damodaran, A. (2012), Investment Valuation, 3rd ed., John Wiley, New York, NY.
Fabozzi, F.J. and Grant, J.L. (2000), Value-Based Metrics: Foundations and Practice, John Wiley, New York, NY.
Fernandez, P. (2002), Valuation Methods and Shareholder Value Creation, Academic Press, London.
Fisher, A.K. and McDonald, J.G. (1972), “New issue stock price behavior”, Journal of Finance, Vol. 27
No. 1, pp. 97-102.
Hoberg, G. (2007), “The underwriter persistence phenomenon”, The Journal of Finance, Vol. 62 No. 3,
pp. 1169-1206.
Holthausen, R.W. and Zmijewski, M.E. (2014), Corporate Valuation, Cambridge Business Publishers,
Lombard, IL.
Jacquier, E., Titman, S. and Yalcin, A. (2010), “Predicting systematic risk: implications from growth
options”, Journal of Empirical Finance, Vol. 17 No. 5, pp. 991-1005.
SEF Jarrow, R.A. and Rudd, A. (1983), Option Pricing, R.D. Irwin, Homewood, IL.
35,2 Kraft, H., Schwartz, E.S. and Weiss, F. (2013), Growth Options and Firm Valuation, National Bureau of
Economic Research, Cambridge, MA.
Koller, T., Goedhart, M. and Wessels, D. (2015), Valuation: Measuring and Managing the Value of
Companies, 6th ed., John Wiley, New York, NY.
Li, G. (2016), “Growth options, dividend payout ratios and stock returns”, Studies in Economics and
272 Finance, Vol. 33 No. 4, pp. 638-659.
Logue, D.E. (1973), “On the pricing of unseasoned equity offerings: 1965-1969”, Journal of Financial and
Quantitative Analysis, Vol. 8 No. 1, pp. 91-104.
Loughran, T. and Ritter, J. (1995), “The new issues puzzle”, Journal of Finance, Vol. 50 No. 1, pp. 23-51.
Lowry, M. and Schwert, G.W. (2002), “IPO market cycles: bubbles or sequential learning?”, Journal of
Finance, Vol. 57 No. 3, pp. 1171-1200.
Margrabe, W. (1978), “The value of an option to exchange one asset for another”, Journal of Finance,
Vol. 33 No. 1, pp. 177-186.
Mauboussin, M. and Johnson, P. (1997), “Competitive advantage period: the neglected value driver”,
Financial Management, Vol. 26 No. 2, pp. 67-74.
Merton, R.C. (1973a), “An intertemporal capital asset pricing model”, Econometrica, Vol. 41 No. 5,
pp. 867-888.
Merton, R.C. (1973b), “Theory of rational option pricing”, Bell Journal of Economics and Management
Science, Vol. 4 No. 1, pp. 141-183.
Myers, S. (1977), “Determinants of corporate borrowing”, Journal of Financial Economics, Vol. 5 No. 2,
pp. 147-175.
Neftci, S.N. (2000), An Introduction to the Mathematics of Financial Derivatives, 2nd ed., Academic
Press, New York, NY.
Pinto, J.E., Henry, E., Robinson, T.R. and Stowe, J.D. (2015), Equity Asset Valuation, John Wiley,
New York, NY.
Ritter, J. (2003), “Investment banking and security issuance”, in Constantinides, G.C., Harris, M. and
Stulz, R. (Eds), Handbook of the Economics of Finance, North Holland, Amsterdam.
Ritter, J. and Welch, I. (2002), “A review of IPO activity, pricing and allocation”, Journal of Finance,
Vol. 57 No. 4, pp. 1795-1828.
Rubinstein, M. (1991), “One for another”, Risk, Vol. 4 (July-August), pp. 30-32.
Schwartz, E.S. and Moon, M. (2000), “Rational pricing of internet companies”, Financial Analysts
Journal, Vol. 56 No. 3, pp. 62-75.
Schwartz, E.S. and Moon, M. (2001), “Rational pricing of internet companies revisited”, The Financial
Review, Vol. 36 No. 4, pp. 7-26.
Shaw, D. (1971), “The performance of primary stock offerings: a Canadian comparison”, Journal of
Finance, Vol. 26 No. 5, pp. 1103-1113.
Wagner, N. (2004), “Time-varying moments, idiosyncratic risk, and an application to hot-issue IPO
aftermarket returns”, Research in International Business and Finance, Vol. 18 No. 1, pp. 59-72.
Corresponding author
Tom W. Miller can be contacted at: tmiller@kennesaw.edu
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
Or contact us for further details: permissions@emeraldinsight.com

Terminal Values For Firms With Growth Opportunities: Explaining Valuation and IPO Price Behavior

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Terminal Values For Firms With Growth Opportunities: Explaining Valuation and IPO Price Behavior

Uploaded by

Copyright:

Available Formats

The current issue and full text archive of this journal is available on Emerald Insight at:

2. Two-stage valuation models

FCFt ¼ NOPATt NINVt (5)

NOPATt ¼ ð1 t Þ EBITt (6)

3. Fundamental model for the terminal value of a company

FCFTþ1 NOPATTþ1 NINVTþ1

ðg=RÞ NOPATTþ1 ðg=RÞ NOPATTþ1 (10)

to the numerator to obtain:

ðR=RÞ NOPATTþ1 NINVTþ1 þ ðg=RÞ NOPATTþ1 ðg=RÞ NOPATTþ1

which simpliﬁes to:

TVT ¼ VOPT þ NPVGOT (13)

NPVGOT ¼ VGOT VICT (16)

NOPATTþ1 ¼ ROCOP BVCT (21)

g NOPATTþ1 ¼ ROCGO NINVTþ1 (22)

to reveal important relationships. (ROCOP/R) is a measure of the competitive advantage

TV0 ¼ VOP0 þ VGO0 VIC0 (25)

4. An option model for growth opportunities

E0 ¼ A0 edA T Nðd1 Þ X0 ed X T Nðd2 Þ (29)

where r J,M is the correlation

4.3 An illustrative numerical example

Correlation between Rates of Return for VGO and VIC

5. An explanation for IPO price behavior

Panel A. Values of the company during the explicit forecast period

Years Correlation between rates of return for VGO and VIC

Panel A. Values of the company during the explicit forecast period

Panel A. Values of the company during the explicit forecast period

You might also like