How Much of a Role Should Default Options Play in Equity Values?

A large collection of finance literature argues that equity securities are subject to potential misvaluation by investors, where the sources of misvaluation are attributed primarily to behavioral biases, such as overconfidence, conservatism and others.

But in a new article pending publication in the Journal of Finance, Professor Assaf Eisdorfer, with co-authors Amit Goyal of University of Lausanne and Alexei Zhdanov of Penn State, provide a new direction, arguing that equity misvaluation is, at least partly, driven by investors’ failure to fully recognize and adequately price the optionality of equity.

Because shareholders have the option to default (or abandon the firm) the value of this option should be an important part of the equity value, he says.

“Everybody knows this, but apparently it is not easy to value the default option, or at least we don’t see much evidence that investors try to do so,” Eisdorfer says. “The commonly used standard stock valuation techniques, such as multiples valuation or discounted cash flow, do not explicitly account for the default option. Using these techniques, therefore, can lead to misvaluation, especially among stocks with high prospects of default or exit.”

“The commonly used standard stock valuation techniques, such as multiples valuation or discounted cash flow, do not explicitly account for the default option. Using these techniques, therefore, can lead to misvaluation, especially among stocks with high prospects of default or exit.” -Assaf Eisdorfer

Take Ford Motor Co. as an example, Eisdorfer says. By late 2008 to early 2009 the automotive giant was in deep financial distress, and the option to default was in-the-money. Yet there was no evidence that analysts from top investment banks incorporated that option value in their analyses. These banks use a variety of standard equity valuation techniques, such as discounted cash flow or long-term enterprise-value-to-sales ratio, and reached very different stock value estimates. For example, the JP Morgan target price for Ford in late October was $2.43 per share, while the Credit Suisse target price was $1 per share.

“We built a structural equity valuation model that explicitly takes into account the value of the option to default,” Eisdorfer says. “And we show that the model works: stocks that are classified as undervalued according to our model earn much higher return in the following months than overvalued stocks, about 11 percent a year.”

“To the best of our knowledge, our paper, Equity Misvaluation and Default Options, is the first to employ a structural option pricing model of default on a large cross-section of stocks to value equity and measure potential misvaluation at the firm level,” he says.

The performance of this model is stronger for companies with more valuable default options, namely small cap, financially distressed, less profitable, and highly volatile companies, indicating that the model captures the misvaluation of the default option.

As expected, the model also performs better around earnings announcements, when uncertainty is more likely to be resolved, and among stocks with lower information transparency, which are harder to value in the first place.

Another interesting supporting evidence of the model is given by observing the actions of firm managers and professional investors, which are typically better informed than retail investors, Eisdorfer says. Overvalued firms are more likely to issue equity, have lower institutional ownership, are sold more actively by insiders, and have lower probability of being acquired than do undervalued firms. All these effects are stronger for firms with more valuable default options, suggesting that the researchers’ results are driven by the ability of the model to identify mispricing of default options.

When the methodology was applied to the cross-section of stocks in a sample of nine most highly capitalized other developed markets, similar results were found in most countries.

An interesting question raised by the research is why investors do not use option-based valuation models to value stocks, Eisdorfer says.

“One potential explanation is the complexity involved in implementing such models,” he says. “We hypothesize that many investors, especially retail investors, do not possess the necessary skills to implement such a model. This conjecture is consistent with prior evidence indicating that many investors make naive and sub-optimal trading decisions, especially when more sophisticated valuation tools are required.”