One can view equity as a call option on assets …
Stocks are options. Since lenders rank above equity investors in a company’s capital structure, we can interprete stocks as options on a company’s assets at a strike equal to debt. This is the asset-view. Taking a cashflow-view have, stocks are options on cashflows after servicing debt (and covenants). Of course, the reality is much more complicated (if we want so).
Path dependency. The ultimate returns that we realize from equity investments can heavily rely on path dependency. Defensive investments rely much less on path dependency vs aggressive investments. The stock price or sentiment, indeptedness and lenders willigness to lend (more), execution on buy backs and much more factors all play a role here.
Ultimate payoff profiles from investments can vary from a (i) narrow range for likely outcomes for bonds or defensive equity investments, or a (ii) medium range for typical equity investments, to (iii) wide ranges for option-like outcomes like aggressive equity investments. Candidates for the latter probably include highly levered companies as
- Teva: legal issues, debt, prices
- Altice US: Ebitda hinges on subs, ARPU and margins, levered buybacks only working with sustained/growing Ebitda and willing lenders
Other candidates might be
- Commodity plays within current environment (depending on commodity prices, leveraged through new invest)
- China Tech. regulations affect
- long-term growth
- profitability levels
- capital allocation (some bad companies might have to be acquired on the way)
One thought on “Some stocks are options (to the power of two)”
I got a little Prosus (learning money only). I didn’t like Tencent investing in games (not productive) which is funny as Guy Spier had the same issue and he got over it so gave me confidence to dabble. I want it as a hedge if BABA doesn’t do so well and JD wins.