Session 24: Distressed Equity as an option

Investing in Equity in a Deeply Troubled Company

The speaker explains the concept of investing in equity in a deeply troubled company and how it is similar to buying an option.

Investing in Equity as an Option

• Buying equity in a deeply troubled company is like buying an option.

• You invest with the expectation that you may lose all your money, but there is also potential for incredible returns.

Implications for Investors

• Option pricing can be used to value equity in deeply distressed companies.

• Deeply distressed companies are those losing money, expected to continue losing money, and have a lot of debt.

Using Option Pricing to Value Equity

The speaker discusses using option pricing to value equity and gives examples from previous sessions.

Recap of Previous Sessions

• Option pricing was used to value young biotechnology and natural resource companies.

• It was also used to value the option to expand or abandon.

Valuing Equity with Option Pricing

• When buying equity, you get ownership, limited liability, and the choice to liquidate.

• Liquidating becomes an option when there is outstanding debt that exceeds the value of the business.

• This looks very much like a call option.

Valuing Equity in Deeply Distressed Companies

The speaker explains how investors can use option pricing models to determine the worth of equity in deeply distressed companies.

Example Scenario

• Assume a business valued at $100 million with one zero-coupon bond outstanding worth $80 million.

• There is also a variance/standard deviation associated with the estimated value of 40% and a riskless rate of 10%.

Using Option Pricing Models

• An investor can use these inputs as part of an option pricing model.

• The underlying asset's value becomes the equivalent of "s" in the model, and the face value of the debt becomes a strike price.

• With this information, an investor can determine how much equity is worth and what interest rate to charge on the debt.

Valuing Equity as an Option

In this section, the speaker explains how to value equity in a company as an option using the Black-Scholes model. He also discusses how to calculate the value of debt and default spread.

Valuing Equity as an Option

• The speaker uses the Black-Scholes model to value a call option for equity in a company.

• He calculates the market value of debt by subtracting the equity value from the overall company value.

• Using these values, he is able to back into an interest rate for the bond.

• The speaker explains that viewing equity as a call option has interesting implications, such as how much it will drop in value if there is catastrophic news.

Implications of Viewing Equity as an Option

• If half of a business disappears, its equity will drop in value but not necessarily become worthless.

• The speaker revalues the option with new inputs after lowering the business's value and finds that equity remains stubbornly intact due to time and help.

• Stock prices for publicly traded companies in deep trouble may stay above zero due to their estimated options values.

Getting Inputs for Real Companies

• To get inputs for valuing real companies, one can do a discounted cash flow valuation or relative valuation.

Valuing Equity in a Distressed Company

In this section, the speaker explains how to value equity in a distressed company using an option pricing model.

Valuing Equity in a Distressed Company

• To value equity in a distressed company, take all of the debt outstanding at the company and add up the face value of all of the debt. Treat the coupons as well as the face value of a zero coupon bond for the maturity of the debt.

• Take a weighted average of the maturities of all of the outstanding debt. Put those numbers in as the equivalent of a zero-coupon bond.

• Convert consolidated debt into one zero coupon bond with a face value equal to that of all outstanding debt.

• Use past stock prices and bond prices for your company or use industry average variances to account for variance in business value.

• Use these inputs in your option pricing model to get a value for equity.

Summary

Valuing equity in a distressed company requires taking all outstanding debt and converting it into one zero coupon bond. Using past stock prices or industry average variances can help account for variance in business value. These inputs can be used with an option pricing model to determine equity value.