Real Options: A Way to Improve Valuation Accuracy in Industry Life Cycle Transitions: A Case Study of Maersk Drilling

Christian Alexander Nissen & Mads-Christian Visby-Carlsen

Student thesis: Master thesis

Abstract

This thesis draws upon real option valuation (ROV), to overcome the shortcomings of the discounted cash flow model (DCF) when valuing companies facing an industry life cycle (ILC) transition. This thesis criticises the DCF-model’s ability to capture the upside value in environments with high volatility. With the aim to solve this issue, this thesis argues that ROV is the best way to capture the upside value in high volatility environments. To test this hypothesis, this thesis applies the combination of the DCF-model and ROV to a case study of Maersk Drilling. Maersk Drilling is identified as a company operating in an industry, which is transitioning from its maturity to decline. This transition has been identified by looking at selected industry characteristics; Industry drivers, market saturation, competitive situation, technical development and lastly, by looking at five financial principles that characterise companies that have transitioned from its maturity to decline.
This thesis defines the ILC transition from maturity to decline as a relatively short period in which the industry experiences characteristics of both the mature and the decline phase at the same time. As a result, this period is more volatile and uncertain than the middle of the phase. After the ILC-transition has been identified, an in-depth look at the DCF-model reveals that volatility will always affect the valuation negatively. The model cannot capture the upside potential of volatility. As a result, it undervalues companies in volatile environments. An in-depth look at ROV, reveals that the upside value of volatility can be captured by considering the managerial flexibility.
Finally, the theories are put to use, and this thesis conducts a valuation of Maersk Drilling based on the DCF-model as well as with the addition of ROV. A comprehensive forecasted budget is estimated and the DCF-model values Maersk Drilling at a share price of USD51.04 (DKK345.10). The ROV is then applied on a business unit level. The chosen business unit is the one with the highest uncertainty, as this theoretically should be the one where managerial flexibility is most valuable. The thesis identifies an abandonment option which, through a five-step framework, is valued at USD 229m. This results in a 10.80% value increase compared to the initial valuation and a fair share price of USD56.56 (DKK382.43).The in-creased valuation implies that the DCF-model on a stand-alone basis undervalues companies in ILC-transitions.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final ThesisMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2020
Number of pages157