Fundamental Capital Valuation for IT Companies : A Real Options Approach

This study attempts to estimate the fundamental capital value of a growing firm by combining two separate capital valuation techniques, namely the corporate debt valuation of Merton (1974) and the rational pricing technique of internet companies of Schwartz and Moon (2000). For simplicity, the Black and Scholes (1973) approach is used to infer an estimate of the value of the debt of the firm, while the valuation technique of Schwartz and Moon (2000) has been used to estimate the total value of the firm. Making use of the fact that firm value is a function of the value of debt and equity, we first derive a closed-form solution for the value of the debt and then estimate the implied fundamental equity values for sample firms in the information technology sector, and show how the share prices are either undervalued or overvalued. Inferences on the risk premium on the debt are also provided