How Real Options Complement DCF Valuations in Industry Life Cycle Transitions: The Case of Vestas Wind Systems and the Wind Turbine Industry

Peter Thorlacius Bondrup

Student thesis: Master thesis


This thesis invokes theory from the field of strategic management to argue for adopting real options valuations (ROV) as a supplement to discounted cash flow (DCF) valuations in the high-volatility environment of industry life cycle (ILC) transitions. The DCF model has long been argued by academics to not fully identify value in firms in industries with high volatility and uncertainty. ROV has been suggested, and to some extent shown, to remedy these issues, and the thesis sets out to test this on the case of Vestas Wind Systems and the wind turbine industry, in the specific setting of industry life cycle transition between the growth and maturity phases. Initially, the characteristics of the ILC transition period are established, and it is shown how the volatility and uncertainty arises as unavoidable factors in this period of an industry’s life. To avoid adding the transition phase as a separate ILC phase, it is defined as both late growth and early maturity, with these two phases overlapping. Following this, the DCF model is examined from the perspective of the findings regarding the ILC transition period, and it is established that the deterministic nature and failure to incorporate upside potential from volatility is likely to make the model undervalue firms in this setting. From the same perspective, the ROV model is analyzed, and found to complement the DCF precisely where it is needed, namely by adding flexibility and incorporating the upside potential from volatility. Lastly, a literature review of the ROV theory confirms the soundness of arguing for applying this combination of valuation methods to firms in transitioning industries. In the review it was found that the abandonment option on business units provides the most fruitful avenue for researching the application ROV to entire firms. Following this, a framework is designed, with which to determine whether an industry is indeed in the transition phase. The case industry chosen is the wind turbine industry, which is found to be in transition, based on the framework’s measurements ‘Industry Drivers,’ ‘Market Saturation,’ ‘Shakeout,’ and ‘Dominant Design.’ Further, uncertainty was shown to be high in all measures. Lastly, a valuation in two parts is performed of the case company, Vestas. Initially, the value of the company is identified, using the ‘classic’ DCF approach, and found to be 16.6 EUR. Following this, the ROV is conducted in five steps. First, the relevant real option for Vestas is identified to be the abandonment option on the manufacturing business unit, as this option quantifies the strategic challenges and flexibilities arising from the ILC transition, and further as the option is relatively easily identified from public financial statements. Second, the DCF value of the manufacturing business is derived from the financial statements, to function as the value of the underlying asset. Third, the remaining option parameters are quantified, that is, maturity is determined to match the DCF forecast horizon, and exercise price is defined as the book value of the assets of the manufacturing division, reduced by a liquidation discount. Fourth, the relevant volatilities affecting the firm are determined, and combined through a Monte Carlo simulation, yielding a total volatility of 37%. Fifth, the option value of 744 million EUR is calculated using binomial lattices, increasing the firm value from 4213 to 4957 million EUR, and the share price from 16.6 EUR to 20.2 EUR. In conclusion, this thesis shows how ROV can be a valuable addition to the DCF when valuing firms in the ILC transition.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2013
Number of pages116