Real options in the Brazilian power generation sector: are domestic equity research analysts blind-sighted, or is it just a temporary glitch?
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2021-12-16
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Colombo, Jéfferson Augusto
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The Real Options theory (“ROT”) states that firms should be approached as a combination of real assets and real options. Even though a significant amount of research has been done on the topic, it is still unclear to which extent domestic equity research analysts build on ROT to evaluate companies in contexts where options are likely to be a relevant source of value. After reviewing 344 (from a total estimated 368) equity research reports or analyses on Brazilian listed power generation companies produced between December 31, 2020, and April 30, 2021, we find that only discounted cash flow (“DCF”) valuation techniques are applied. No single mention to ROT is made. To estimate the magnitude of such potential misvaluations, we use the Black-Scholes method to price the official growth plans made publicly available by each of those 15 companies between December 2020 and April 2021 and compare the outcome with the analysts’ forecasted equity value upside for each company. Our results suggest that local equity research analysts have ignored a sizeable intrinsic value to these companies by failing to incorporate ROT to their Target Price calculations. Behavioral biases, technical limitations, lack of ongoing sector change perception, and low power sector representativeness at IBOVESPA may explain this phenomenon. Overall, our research highlights the need for local analysts to adjust their traditional DCF-based approaches to capital-intensive companies in an increasingly de-regulated environment, incorporating techniques better suited to capture (not discount) the value of such increasing volatility.