Real options versus discounted cash flow models in the Brazilian energy and infrastructure industry: do valuation results materially differ and why are real options still underrated by sell-side analysts?

Between 2014 and 2024, Brazil allocated an average of 1.88% of its GDP to infrastructure investment, even though at least 4.00% would be required for long-term sustainable GDP growth. If the public sector’s persistent budgetary constraints limit the former’s capacity to close this gap, the private sector has been giving clear signals that it may fulfill it, as long as equity returns justify. Given the substantial embedded optionalities inherent to infrastructure projects in Brazil, in a scenario of increasing deregulation, Real Options (RO) valuation methodologies become potentially powerful capital budgeting tools. On the analytical side, however, very few Brazilian sell-side equity research analysts apply RO methods to value energy and infrastructure firms, even though such optionalities may imply a significant source of value. This omission may lead to misallocation of capital and underinvestment. In this thesis, we: (i) examine all 42 Brazilian energy and infrastructure companies listed on the B3 stock exchange as of March 2024; (ii) employ two RO valuation techniques to assess the economic value of each firm’s long-term growth plans and compute an RO-derived share price per company; (iii) compare the latter with the corresponding target share price from traditional DCF-based sell-side equity research models. Base case aggregated industry results reveal that RO share price valuations are 28-36% higher than DCF’s. We backtest the model using weekly data over a three-year window, and find that: (i) although DCF is a more accurate share price predictor, a significant 43% of all 37 companies eligible for back-testing record RO as the most suitable model, (ii) contrary to intuition, RO is found to be the best model for companies with a lower growth component relative to its share price; (iii) positive alpha-generating share portfolios can be built based on the best model (RO or DCF) assessment. Finally, we survey all 80 energy and infrastructure sell-side equity research analysts in Brazil, and assess the main reasons why RO is underused. Although no statistically significant profile of either RO users or RO-acquainted analysts can be devised, the tests performed indicate: (i) a positive correlation between level of education and use of RO; (ii) knowledge of more sophisticated valuation techniques may lead to a higher familiarity with RO; and (iii) valuation experience abroad may increase the chances of RO use.