European Management Journal Vol. 20, No. 5, pp.
512–526, 2002
Pergamon
PII: S0263-2373(02)00102-0
Stock Market Valuation
with Real Options:
Lessons from Netscape
ADRIAN BUCKLEY, Cranfield University
KALUN TSE, University of Nyenrode
HERBERT RIJKEN, Free University, Amsterdam
HANS EIJGENHUIJSEN, Free University, Amsterdam
Discounted cash flow is the main tool for valuing
projects and companies. Real options techniques
can augment valuation. The case of Netscape is
used to demonstrate this. We begin with a defens-
ive cash flow scenario. On top of this, we superim-
pose a number of real options valuations. Some
experts would dispute our methodology because it
is not built upon market-priced risk. Nonetheless,
it provides an approximate valuation. We prefer
equity valuation using various methodologies,
including real options where appropriate, to arrive
at a range of value. But we cannot, using financial
logic, justify the high Netscape flotation price.
 2002 Elsevier Science Ltd. All rights reserved.
Keywords: Stock market valuation, Real options,
Volatility, Competitive advantage period
Introduction
Frequently, firms make commitments which are
deemed to be significant in pursuing their desired
direction, whether or not, according to the normal
implementation of the discounted cash flow (DCF)
model, they promise a positive net present value.
These are often called strategic investment decisions.
They are akin to investments in the question mark
segment of the Boston box – although not exclus-
ively so.
Under traditional DCF analysis, anticipated cash
flows are critical in developing the necessary dataset
for investment appraisal. Of course, any such analy-
sis can only be as good as the assumptions under-
pinning the input numbers. And these are usually
scrutinised in detail. Sensitivity analysis and scenario
512
 2002 Elsevier Science Ltd. All rights reserved.
Printed in Great Britain
0263-2373/02 $22.00 + 0.00
analysis, if necessary, provide greater depth of
understanding and add sophistication to the
appraisal. This embraces looking at the effects upon
potential payoffs of changed key variables and ask-
ing ‘what if’ questions. It may involve looking at
potential results assuming different sales projections
or higher cost levels or different timing of sales pen-
etration or varying competitive responses. Some-
times, decision trees are incorporated into financial
appraisals and sometimes Monte Carlo simulation
adds further insights. Nowadays, real option valu-
ation techniques are beginning to be applied to aug-
ment DCF appraisals.
In traditional investment appraisal, the angle that is
so often taken is a static one. Operating decisions are
viewed as being fixed in advance thus giving rise to
a base case set of incremental cash flows. But the
ability of managers to alter policy and tactical direc-
tion away from the base case scenario as new infor-
mation becomes available should contribute value
potential. Investments possessing this flexibility are
rather like options. Research and development is an
example. Testing a new market or product is another.
Oil exploration and mining projects fall into this cate-
gory. Levels of exploration, investment and extrac-
tion are contingent upon prices prevailing and tem-
porary closure or complete abandonment are choices
of action dependent upon actual prices and/or levels
of demand. Projects with scale-up possibilities and
sequential investments are examples too. Inter-
national investment often begins with a small com-
mitment which may be scaled upwards should the
environment prove profitable, or it might be curtailed
if the host country appears to offer less attractive cash
flows than anticipated. Furthermore, with a pro-
duction and/or distribution network set up in a host
country, multinationals are more readily able to mar-
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002

ket other products in their portfolios into the foreign
territory. Closely allied to these ideas, multinational-
ity endows production flexibility to source from the
most cost-effective location, which may alter as
exchange rates, labour costs and other key inputs
vary through time.
All of the above instances have a common feature —
the firm has flexibility in respect of its course of
action depending upon outcomes and factors
unknown at the time of the project’s original incep-
tion. This is what real options analysis is all about.
The ideas summarised here are expanded upon in
Buckley and Tse (1996) which appeared in this jour-
nal. The classic, single outturn, non-option orientated
DCF analysis ignores the tactical flexibility which
every good manager tries to retain by maintaining
options that promise upside potential and/or limit
downside risk.
In this paper, we apply the ideas of real options
analysis to the valuation of stock market equities
where growth potential is significant. However, our
approach is a sober one very much at the opposite
end of the spectrum to dot.com mania. In order to
summarise our approach to real options valuation of
equities, we present the sinews of options analysis
and then apply them to value the US firm Netscape.
Real Operating Options
The ability to alter strategic and/or tactical course in
response to new information can contribute signifi-
cant increments to value. This kind of flexibility
should be given due weight at the investment
appraisal stage. Investments possessing flexibility
have the characteristics of options.
Financial options give the holder the right to acquire
or sell something at a specified price (the strike price
or exercise price) within a predetermined timef-
rame — but there is not an obligation to do so. With
many investment projects, the firm acquires an
opportunity (not necessarily a right) to do something
but it is not committed. So, although not identical,
the similarity of such situations to financial options
is clear.
Research and development gives the firm the right
but not the obligation to scale-up from pure research
to pilot plant to the full commercial scale, subject to
meeting various regulatory requirements. Oil explo-
ration rights or possession of mining reserves give
the firm the opportunity to extract (which may, or
may not, be a right because of planning consents and
so on) but not the obligation to do so. Small-scale
expansion into a foreign territory gives the firm the
possibility (again, it may not be a right) of scaling up
should things turn out attractively, but to abandon
should outturns be less positive. These investments
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
REAL OPTIONS
are similar to options in stock market terms and
might, logically, be valued accordingly.
A call option in the stock market gives the holder the
right to buy shares at a particular price over a period
of time, but not the obligation to do so. Similarly, a
successful investment in research gives the firm the
potential to reap the benefits thereof for the cost of
development and subsequent commercialisation. The
owner of a mine or oil well has the possibility of
acquiring the proceeds from the mine or oil well’s
output but does not have an obligation to do so. Like
the stock market call option buyer, the mining or oil
company may defer selling the proceeds of the asset’s
output. Pre-emptive investment in new, including
international, markets may give the firm the edge
when it comes to opportunities for scaling up to a
full sized production and distribution network whilst
retaining the option to withdraw from that market if
results are less than favourable. In respect of research
and development, minerals extraction projects and
exploratory investments in new markets, including
international ones, classic DCF techniques, unless
seriously modified, fail to take into account the tacti-
cal flexibility and value-creating upside potential of
subsequent add-on aspects and consequently under-
state true investment potential. But the enhancement
of the base case DCF valuation by incorporating real
options analysis needs to be approached with the
utmost caution.
The Application of Real Operating
Options Ideas
Various articles have appeared in the literature
stressing the need to extend the analysis of invest-
ment decisions to embrace these option-type charac-
teristics. A number of these were cited in an earlier
paper — see Buckley and Tse (1996) — in this journal.
Such applications of real options analysis have
embraced valuation of resource reserves, including
mining and oil exploration projects, various aspects
of corporate strategy, development of and valuation
of pharmaceutical research and development, ven-
ture capital investment and financing, forestry
resources management, urban land valuation, valu-
ing patents and even investment irreversibility in the
presence of ecological uncertainty. Other applications
have focused upon operational flexibility (the option,
for example, to fire a boiler with coal, natural gas or
oil), multinationality as endowing production
options plus various applications in microeconomics.
It is interesting to note that, in a survey study of FTSE
100 companies, it was found, by Busby and Pitts
(1998), that, whilst few firms have formal procedures
for evaluating real options, some have rules of thumb
for qualitatively assessing them and it also appeared
that respondents possessed a somewhat inadequate
513
REAL OPTIONS
acquaintance of the work being done on real options.
This, presumably, reflects this topic as being at the
very frontiers of business knowledge. In another Eur-
opean-based survey, real options were found to be
quantified by some oil and minerals companies and
qualitatively allowed for by a few firms in high
growth areas — see Buckley et al. (1996). A more
recent investigation of the practice of 34, mainly
American companies, by Triantis and Borison (2001)
found real options to be used as a strategic way of
thinking, an analytical valuation tool and as a means
of evaluating, monitoring and managing capital
investments. Quantification seemed most prevalent
amongst oil, energy and commodity companies. It is
worth noting that the sample used in this investi-
gation comprised self-selecting, large, sophisticated
companies and the individuals within such firms
responded because of an interest in the topic,
expressed either by conference attendance or by vol-
untarily reporting their efforts to implement real
options ideas.
Financial Options and Real Options
As stated earlier, a call option on a share gives the
holder the right to buy shares at a particular price —
the exercise price — for a limited time period, but
the holder does not have the obligation to buy the
shares. The option is only exercised if it is profitable
to do so (technically, this is not quite correct since
the holder may merely sell the option on to a new
purchaser). A put option gives the holder the right
to sell shares at a specified price during a window of
time — but not the obligation to do so. Options exist
on many company shares, stock market indices, some
commodities and currencies. All of these options are
called financial options because they relate to finan-
cially traded contracts. Real options are opportunities
held with respect to a possibility to achieve some-
thing in the real economy as opposed to an opport-
unity relating to a claim traded on a financial
exchange.
Thirty years ago, Black and Scholes (1972) published
their seminal paper on valuing financial options. The
key drivers of value in their model may be
described as:
❖ intrinsic value — the difference between the mar-
ket value of a share and the exercise price under
the option. If this provides a profitable opport-
unity, the option is said to have positive intrinsic
value. If it would result in a loss, however, the
intrinsic value is said to be zero since no holder of
such an option would, logically, exercise it
❖ time — the amount of time the option has to run
to its expiration
❖ volatility — the extent to which the share is likely
to oscillate during the period remaining until the
option expires
514
❖ interest rate — since a call option holder can defer
payment for shares (except in respect of payment
of the option downpayment, technically called the
option premium), the interest rate is clearly perti-
nent through the time value of money. Buying
shares through the cash market and through
options have different cash flow timings, hence the
relevance of the interest rate.
We would also mention, in passing, that some
options are called American options and some are
termed European options. With the former, the
option holder can exercise the option at any time
until expiry. With a European option, it can only be
exercised at expiry. Of course, both types of option
can be traded on appropriate financial exchanges
and, thus, sold on in the secondary market prior to
expiration. Black and Scholes formulae for valuing
European options are given in Table 1.
The value drivers of a real option are very similar to
those with respect to a financial option. The exercise
price in a financial option is similar to the amount of
capital expenditure required to be committed under
an investment opportunity. The stock price under a
financial option is comparable to the present value of
cash inflows resulting from committing to a real
option. The time that a financial option has to run to
expiry is comparable to the amount of time for which
a particular real option commitment can be profitably
deferred. Volatility of stock returns in a financial
option is precisely similar to the volatility of potential
project inflows (this is self-evidently difficult to spec-
ify in advance). Finally, both with financial options
and real options, since the exercise price can be
deferred, the risk-free rate comes into play. With fin-
ancial options, the exercise price is fixed and not sub-
ject to risk. With real options, the amount of capital
expenditure to be committed is usually uncertain. In
order to meet the requirements of option pricing
models, it is most usual to think of capital expendi-
ture to be paid in terms of certainty equivalents,
enabling the risk-free rate to be used to value the real
option. Evidently, there is a close affinity between the
value-creating variables in financial options and real
options — see Table 2.
With a financial option, it can be shown that changes
in the key value drivers in the Black and Scholes for-
mula impact the value of a call option and a put
option in the manner described in Table 3. Note that
the tabulation shows the practical effect of dividends
upon financial option valuation. The original Black
and Scholes model (see Table 1) applied to non-divi-
dend-paying companies but it is readily adapted to
allow for dividends payments.
Transplanting these ideas to the real option arena
suggests messages for managers in their creation and
defending of real options within the firm. These
propositions revolve around the Black and Scholes
value drivers, namely the present value of expected
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
 REAL OPTIONS

Table 1 Black and Scholes Formulae

XN(dist2)
C = SN(dist1)⫺
ert
C is the price of the call option
S is the current price of the shares σ2 is the variance of the continuously compounded rate of return on the
share. So σ is the standard deviation
X is the exercise price
t is time to expiration, expressed as proportion of 1
ln(S/X) + (r + σ2)t
a year 2
dist1 =
r is the continuously compounded riskless rate of σ冑t
interest
e is the base of the natural logarithm, or 2.71828
dist2 = dist1⫺σ冑t
N(dist1) and N(dist2) is the value of the cumulative
normal density function. A statistical term, found
from tables showing the area of the normal distri-
bution to the left or right of the mean
Put = Call + PV(X)⫺S

Table 2 Financial Option and Real Option Key Variables

Financial option (call option) Variable Real option (project)

Exercise price X Expenditure required to acquire the assets

Stock price S Present value of the operating assets to be acquired
Time to expiration t Length of time decision may be profitably deferred
Variance of returns on stock σ2 Riskiness of the underlying operating assets
Risk-free rate of return r Time value of moneya
a
Affinity with the Black and Scholes formulation is achieved if the expenditures involved in acquiring the assets under the real
option are converted into certainty equivalent terms and a risk-free rate is then applied to X. Note that the certainty equivalent of
a capital expenditure will be greater than the best estimate

Table 3 Value Driver Movements And Option Premium Effects

The variables Rise in variable

Influence on a call option Influence on a put option

Share price (underlying asset) Increases Decreases

Exercise price Decreases Increases
Time-to-maturity Increases Increases
Volatility of share price Increases Increases
Interest rate Increases Decreases
Dividend payments Decreases Increases

inflows (S), the present value of expected outflows
(PV of X), extending the real option’s life (t), and
increasing the firm’s ability to respond to uncer-
tainty — its flexibility (σ).
In essence, the major practical points for managers to
bear in mind in terms of enhancing real options value
are set out below.
❖ Increasing the present value of expected inflows
(S). Consider:
–focusing upon price, volume and costs
–building customer switching costs
–sourcing almost exclusively from lowest cost
producer
–creating sequential opportunities (situations in
which, if round 1 of an investment turns out well,
further investment in round 2 follows, and so on)
–attempting to control key resources
–taking pre-emptive positions may ward off com-
petitors by increasing their entry costs and lower-
ing the present value of their base case cash
inflows
–arranging exclusive raw materials supply con-
tracts would reduce competition
–arranging exclusive distribution channels would
also reduce competition
–differentiating the potential product or service.
❖ Reducing the present value of expected outflows
(PV of X) either alone or in partnership. Consider:

European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002 515
REAL OPTIONS
–lowering capital costs or taking capital costs in
bites with abandonment or scale-up possible.
This reduces the risk of a big failure
–obtaining economies of scale
–creating economies of scope
–outsourcing.
❖ Increasing management’s ability to respond to
uncertainty in potential product markets. This
enhances the value of flexibility and, in real
options projects, this is a good measure of σ (see
Luehrman, 1998). Consider:
–taking pre-emptive, low cost positions. This
defers full-scale investment and may endow
flexibility
–taking pre-emptive positions better enables the
firm to respond to new information becoming
available
–timing investment at troughs
–outsourcing increases flexibility.
❖ Extending the real option’s maturity (t). Consider:
–taking pre-emptive low cost positions sufficient
to ward off potential competition patenting
–obtaining exclusive raw materials supply con-
tracts
–creating exclusive distribution channels
–building switching costs
–controlling key resources
–seeking advantageous alliances.
Equity Valuation and Real Options
We now turn to the major topic of this paper which
is to apply real options techniques to the valuation
of relatively high growth companies. In so doing, it
may be interesting to report the findings of a very
informal poll with results from forty investment
banks. The survey, undertaken in the summer of
2001, revealed that 80 per cent reported that they
were seeking knowledge or monitoring real options
developments and over 32 per cent had experi-
mented with real options techniques to value high
growth stocks (although the only cases that we found
of published research reports from investment banks
using the technique were for oil, mineral or com-
modities companies). We did find cases, though,
where real options techniques had been used to price
off-balance sheet assets, such as broadcasting licenses
and airport slots. Interestingly, by mid to late 2001,
half of the investment banks polled had reduced their
staff specialising in real options services compared
with the previous year. This coincided with a down-
turn in investment banking profitability and
employee numbers, reflecting lower stock market
levels and a decline in corporate finance activities in
the wake of the dot.com boom.
516
It is interesting to note that we have found evidence
from others than investment banking groups publicly
pronouncing on stock prices via real options. For
example, at the end of 1999, shortly after the flotation
of Tiscali, the Italian internet service provider, Mical-
izzi argued, in the Italian financial press, that the firm
had options on the e-commerce market not only in
Italy but in other European countries and possessed
unpriced options on internet services to third gener-
ation mobile phone users. The impact of allowing for
these omitted real options was to produce a valuation
of 309 per share versus the target IPO price of 67.
The share price duly responded and, indeed, overre-
acted, peaking at 1100 per share. More detail is
available in the financial magazine Risk (2000).
Also, Wildberger and Georgeson (2001) use real
options techniques, in an INSEAD case study, to
value the stock of the online bank Egg. They use a
complex valuation model with more than forty input
variables. The model rather accurately prices Egg
equity.
In stock market terms, real option value may be
imputed from the fact that the total market value of
the firm’s ordinary shares exceeds the estimated equ-
ity value of the existing businesses of the firm. This
estimated value would flow from a discounted cash
flow analysis of assets in place, that is exclusive of
growth opportunities, giving a fundamental value of
operations. This would be followed by adjustments
for surplus assets and debt. The difference between
market value and the fundamental value of equity,
arrived at as above, is termed market-imputed real
options value by Rappaport and Mauboussin (2001).
Netscape’s Valuation using Real
Options
To get to grips with real options valuation, we use
the case of Netscape Communications Corporation
(Netscape). At the outset of this section, we clearly
acknowledge that a full analysis of Netscape’s poten-
tial would require insights into technology and an
appraisal of a business franchise in a rapidly chang-
ing environment far beyond what is presented here.
Even with this knowledge, valuing companies riding
the waves of technology is especially difficult. Our
simplified approach here takes technology issues as
given and focuses specifically upon valuation prob-
lems. Netscape was founded in April 1994. Netscape
described its businesses in the prospectus for the
initial public offering (IPO) of stock in the company
as follows. Netscape ‘develops, markets and supports
open client, server and integrated applications
software that enables information exchange and com-
merce over the Internet and private Internet Protocol
(IP) networks.’ The vital product in the Netscape
portfolio was the browser, termed the Netscape
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002

Navigator, with its superiority to anything that
existed in the market place at the time of its launch
and immediately following. Kay (2002) describes the
early Netscape story as follows:
It begins in California, in 1994. Jim Clark, absurdly rich
from his success at Silicon Graphics, the high-end com-
puter maker, is in search of the next new thing. He sees
the potential of making the Internet available to novices.
The best browser has been written by a student at the Uni-
versity of Illinois, Marc Andreessen. Mr Clark hires Mr
Andreessen and his friends, rebuilds the browser from
scratch and settles the inevitable law suit with the Univer-
sity of Illinois.
He goes on, significantly, to add that potential com-
petition is waiting in the wings.
Microsoft, meanwhile, has been slow to grasp the signifi-
cance of the Internet but is worried about the threat from
browsers.
By August 1995, the time of its stock market flotation,
valuation of Netscape was complicated since the firm
had not yet generated any positive net cash flow, nor
had it yet made a profit. Despite the evident valu-
ation problems, Netscape’s lead underwriters pro-
posed, at the company’s IPO, a doubling of the orig-
inally planned offer price from $14 to $28 a share.
This followed massive enthusiasm from would-be
investors for the shares, demonstrated at roadshows
arranged by the sponsoring bankers. This also
resulted in the underwriters and the company
arranging for the number of shares to be offered to
be increased from 3.5 to 5 million. The new proposal
meant that a business with a net book value of just
over $16 million prior to the input of net new money
(that is, net of underwriters fees and other issue
expenses) of around $127 million and no track record
of profit yet, indeed, virtually no track record at all,
would be valued at over $1 billion. Evidently, poten-
tial investors were viewing the stock as a ‘must-have’
investment for their portfolios. Perhaps they were
looking upon it as the next Microsoft. We suspect
that there was little discounting of future cash flows
to underpin the valuation, and we suspect that $28
per share was arrived at simply as a reflection of the
apparent enthusiasm for the issue and a gut feel on
the part of Netscape’s financial advisers about what
price they could get for the stock. At the time of its
IPO, Netscape was essentially a large real option — a
call option on the company’s potential in the browser
market. Nonetheless, we set out to model a base case,
using discounted cash flow analysis, which would
justify the initially mooted price per share of $14. We
then look at using real options valuation (ROV) in an
attempt to justify the higher price of $28 per share.
Whilst doing this, we point out a number of lessons
that might be learned in applying ROV to equity
valuation and we suggest more rational valuations
for Netscape.
Our real option valuation of Netscape begins with a
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
REAL OPTIONS
defensive base case valuation and it is on top of this
that the real option scenario1 is superimposed. We
would stress that, as we make clear elsewhere, valu-
ation of high growth companies is perfectly feasible
using standard discounted cash flow without real
options analysis. But, of course, the valuation model
would incorporate upside potential within the fore-
cast cash flows and these would, therefore, be
pitched at a level higher than our defensive base case
scenario. We would also point out that we have
viewed Netscape’s whole operations as a single stra-
tegic business unit (SBU) and allowed for a real
option scenario built upon it. In practice, it would
be more realistic to value companies by specifying
scenarios for their various SBUs with real option
valuations superimposed as appropriate, but not
necessarily for each SBU since some would be ex
growth.
It is also acknowledged that a fuller modelling
includes attempting to put a value upon other
options — see, for example, Arnold (2002) — since
true valuation accords with the equation below.
True NPV =
NPV of assets in place +
NPV of expansion option +
NPV of abandonment option +
NPV of other options (including timing)
We have excluded abandonment and timing options
from our figuring on Netscape because the magni-
tudes of the key variables in these areas are not speci-
fied upfront. Furthermore, they are likely to be sub-
ject to change during the life of the option. As
Damodaran (2000) points out in respect of the aban-
donment option, this is so often the case.
In order to model a defensive base case set of figures
for Netscape, we begin from the information avail-
able at the time of the IPO. In other words, we take
an ex ante view. We attempt to avoid any hindsight
bias. The actual figures from which we build our esti-
mates appear in Table 4 and the sinews of the cash
flow forecast are summarised in Figure 1. The full set
of valuation calculations are available to interested
readers and may be obtained from the first men-
tioned author of this paper. We assume a five year
compound growth rate in sales of 50 per cent per
annum over and above the 1995 estimated level with
this growth rate moderating to 25 per cent per annum
compound for a further five years. Cost of revenues
are assumed to remain at just over 10 per cent of sales
revenues (the same as the level prevailing in Table
4) but R&D continues to be high at just over 36 per
cent of sales revenues, reflecting the need to innovate
in a fast-changing industry. Operating expenses and
capital expenditures are assumed to settle, respect-
ively, at 21 per cent and 10 per cent of sales — well
below the level prevailing over the short history of
the company prior to the IPO. With this background,
the base case scenario indicates free cash flow becom-
517
REAL OPTIONS

Table 4 Netscape Early Cash Flows

From IPO prospectus Our estimate

Figures in US$ (mn) Inception (April 4, 1994) to Six months ended June Twelve months
December 31, 1994 30, 1995 ended December 31,
1995

Revenues 0.7 16.6 33.3

Cost of goods sold (0.2) (1.7) (3.5)
Gross profit 0.5 14.9 29.8
Research and development (2.0) (6.1) (12.2)
Other operating expenses (6.9) (13.4) (26.9)
Operating income/(loss) (8.4) (4.6) (9.3)
Taxes - - -
Net income/(loss) (8.4) (4.6) (9.3)
Additional capital (2.6) (5.0) (12.0)
Depreciation 0.2 0.7 2.0
Free cash flow (10.8) (8.9) (19.3)

Figure 1 Defensive Cash Flow Forecast for Netscape

ing positive in 1999 and growing to a sustainable per-
petuity of over $127 million in 2005. With a discount
rate of 12 per cent, this scenario indicates a base case
value per share of over $15, slightly in excess of the
original IPO target of $14 per share. But even this
valuation may look optimistic to some readers,
especially with the benefit of hindsight (which we are
attempting to avoid). However, our approach is used
to demonstrate how real options may be used to
arrive, ultimately, at a rational valuation for Netscape
at the time of its IPO.
Now, we superimpose a ROV scenario. In doing so
we are not abiding by the prescription of Amram and
Kulatilaka (2000). They define real options as the sub-
set of strategic options in which the exercise decision
is largely triggered by market-priced risk. They
further define market-priced risk as encompassing
risk that may be captured or priced by a traded secur-
ity. For example, oil price fluctuations are a market-
priced risk because they are captured in the value of
oil futures contracts. Risk outside of this definition is
termed private risk. We are aware that, in trying to
use real options to price Netscape equity, we are
dealing with private risk. Our argument in favour of
using real options to price a private risk revolves

518 European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002

around the fact that the technique may give us the
wherewithal, approximately, to price the share. We
are aware that this approach lacks the authority of
pricing via a market-priced instrument. But in our
search for a valuation guide, we feel that it may pro-
vide a useful indication, albeit hazy. Furthermore, we
are of the opinion that valuation is not an exact
science. We would argue that what we are seeking is
a range of likely value and that in pursuit of this goal
it is reasonable to use a multiplicity of valuation
tools.
We are aware that we could be accused of introduc-
ing bias into the valuation. It is true that ROV uses
subjective data. This creates potential for massaging
figures. Investors, hunting the holy grail of reason-
able valuation, would wish to minimise bias. Of
course, the scope for bias is equally present with DCF
valuation where cash flow forecasts are also subjec-
tive. Investment banks may be prone to bias in wish-
ing to justify a high IPO price. From the investor’s
standpoint, we like the idea of introducing a number
of logical sensitivities aimed at providing a range of
reasonable values.
Returning to the Netscape financial model, we find
that, in the steady state arrived at when growth has
moderated, there is a relationship of cash costs
(including taxes) to contribution (sales minus vari-
able costs) of 81 per cent.2 This ratio implies an exer-
cise price of 81 (including taxes) which would achi-
eve 100 of contribution. With a risk-free interest rate
of 7 per cent per annum, a volatility factor of 60 per
cent per annum and an assumed period over which
this upside volatility is likely to be present (t)
amounting to 20 years, the Black and Scholes formu-
Figure 2 Illustration of High and Low Trajectories
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
REAL OPTIONS
lation produces a value per Netscape share equal to
$28. Our choice of volatility and time factors are
based on reverse engineering to justify $28. We do
not have confidence in their reasonableness, as will
be demonstrated later.
We have applied the volatility factor to the defensive
base case cash flows and then assumed that cash
flows level out at a high (with volatility) trajectory
level — this is illustrated in Figure 2. Given the
notation in the figure, if the areas of present value A
and B (the base case) are put together (that is, if B is
rolled back to before time t and added in with A),
then C plus D represents the real option value by
which the defensive base case value (A plus B) is
enhanced. We have used this approach not because
we believe it to be the best route to valuation but
because it arrives at a value of $28 per share and
because it also illustrates a fault. Surely it makes
more economic sense to assume that cash flows fall
back, after the volatile period towards the defensive
base case scenario. Referring to Figure 2, this means
that after year t free cash flow falls back towards the
base case scenario — that is, the low trajectory level.
In other words, the only real option increment is the
area C and this represents potential volatility value
based on area A. So, the total valuation on this basis
is A plus B plus C. As an example, consider the valu-
ation of a pharmaceutical product which is patented.
The product is forecast to generate a defensive base
case set of cash flows, say for 30 years. But assume
that the patent rights have 15 years to run. We model
enhanced value during this period by building in an
option pricing structure with the appropriate σ and
a t factor of 15 years. After year 15, generic competi-
tor drugs will probably enter the market. This results
519
REAL OPTIONS
in the firm experiencing cash flows which return to
the defensive base case scenario. Competition pre-
vents them from remaining at the high trajectory
level.
In Figure 2 we set out the essence of the high and low
trajectory paths. We believe that the lower trajectory
provides a more logical modelling of likely outcomes
because it suggests a return to the base case scenario
after the highly volatile early period. We have little
confidence in the high trajectory assumptions under
which outturns in excess of the base case perpetuate
after the early volatile period. Using the low tra-
jectory approach plus a volatility factor of 60 per cent
and a t of 20 years produces a value per share of $25
for Netscape.
As a technical aside, we use a dividend-paying Black
and Scholes formulation here to value Netscape’s real
option.3 The reason is that the option value erodes
with time (as technology changes and new competi-
tors emerge) and this is best simulated with the divi-
dend-paying model. This is not because a dividend
is actually being assumed to be paid by Netscape but
it models a tapering in value just as payment of divi-
dends results in an ex dividend share price reflecting
the lowering of value that remains within the corpor-
ation. Further detail on this topic is available in Dam-
odaran (2000).
The line referred to in Figure 2 as ‘upside created by
potential volatility’ is a straight line the angle of
which is consistent with volatility. Were volatility
higher, the slope would be more vertical: if it were
less, the slope would be more horizontal. What this
line reflects is the firm having the opportunity
profitably to do more business year by year whilst
its competitive advantages are firmly in place — in
the figure this goes out to year t. Put more techni-
cally, the firm may exercise a strip of options year by
year in which the strike price is 81 and the payoff is
100. More realistically, of course, the firm is poten-
tially exercising its options continuously rather than
year by year. This gives rise to the smoothed slope
rather than a stepped upward line which would be
obtained were options exercised annually. Valuation
using a strip of options gives a very similar result
to that obtained using a dividend-paying Black and
Scholes formulation. Using a strip of options may
have advantages where the desire is to value a pla-
teau development of upside volatility rather than the
peaking development shown in Figure 2.
The volatility factor of 60 per cent and the time factor
(20 years) used above are mere assumptions.4 How-
ever, this volatility figure is similar to that used by
some businesses for high growth projects. For
example Merck, the pharmaceuticals giant, is
reported — see Nichols (1994) — to use this figure
as a conservative measure of biotechnology volatility.
To be precise, Merck executives indicate a volatility
range of 40–60 per cent. Of course, it may be argued
520
that in the Internet world the appropriate figure
might be higher. Indeed Amran and Kulatilaka (2000)
and Rappaport and Mauboussin (2001) suggest vola-
tility benchmarks as high as 90–125 per cent per
annum for biotechnology and Internet firms, respect-
ively.
But, bear in mind the figure of 20 years that is incor-
porated into the valuation as being the time period
over which Netscape is effectively assumed to main-
tain a competitive advantage such that it is enabled
to scale up its operations, if appropriate, whilst main-
taining profit margins — such a scenario implies
fairly compliant competitors. Indeed, this is like a
patent with a 20 year life. And here is the rub of ROV.
Valuations based upon real options ideas are highly
sensitive to assumptions made about the magnitude
of t. In the Netscape case, this is a particularly perti-
nent point since a would-be competitor at the time
of the IPO was Microsoft — hardly a compliant
potential adversary.
Sometimes, the value of t is fairly clear — for
example, a patent gives the owner the right to its use
and exploitation for an explicit period of time. In
such a case, the owner of the patent has acquired a
specific competitive advantage period (CAP) — see
Mauboussin and Johnson (1997) — over which the
holder of the patent is largely insulated from direct
competition. In other words, the firm has a would-be
sustainable competitive advantage, which potentially
creates a source of super-normal profit — that is, a
driver of excess returns. Such a situation justifies a
fairly high value of t, towards the high end of the
term of the patent. We use this form of words
because imitators may manage legally to circumvent
the rights in the patent or develop new technology
which meets customer needs and ousts the patent-
holder from pole position. Of course, it is not enough
merely to possess a patent. All of the ingredients for
profitable, cash generative exploitation have to be
there too.
More often than not, of course, there is no defined
period over which a firm has rights to a project. Most
often, a firm’s opportunities are less than clearly
specified, both in terms of exclusivity and in terms
of time. A firm may have a lead in the development
of an option. This may create an exclusive opport-
unity ahead of competitors, but for a limited per-
iod — until they catch up. The rights that the leader
has are not legal rights (like with a patent) and they
will surely erode — and maybe faster than antici-
pated by the incumbent firm. In these circumstances,
the expected life of the competitive advantage is only
an uncertain estimate. First-mover advantages,
unless substantially protected in some way or the
other, fall into this category. Damodaran (2001) suc-
cinctly summarises this in developing a continuum
of follow-on investment value; we have adapted and
reproduced this in Figure 3. The figure suggests that
high option value is associated with situations where
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002

Figure 3 Continuum Showing Option Value from Follow-On Investments
there is an exclusive right to a follow-on opportunity
and that sequential investments must possess sus-
tainable barriers to entry to achieve sustainable
excess profits. Of course, paying too much to achieve
this exclusivity can destroy the potential for excess
returns (telecom licences, maybe) as can less than
competent management. Note the position of the
pure first-mover advantage to the left of the figure.
The relatively weak position of first-mover busi-
nesses with little protection from potential compe-
tition is substantiated by Cottrell and Sick (2001)
who, having undertaken a survey of recent research
and experience, conclude that ‘we do not mean to
imply that first-mover advantages do not exist or are
never important for strategy. Our aim is, rather, to
show that there are limits to the value of first-mover
advantages, and that such limits should be carefully
weighed against successful imitator strategies that
provide a valuable option to delay. First-mover
advantages may not be that important after all’.
If Netscape were assumed to possess a first-mover
advantage sustainable out to eight years and if vola-
tility were as high5 as 125 per cent, it can be shown
that the value of the firm’s equity would be only a
modest amount more than in the base case, at $18 to
$19 per share (this figure results from the low tra-
jectory6 approach: the high trajectory gives a value of
$29 per share). Very modest increments on base case
value are typical with unprotected first-mover
advantage (therefore a truncated CAP), and this is
especially so when cash inflows are loaded towards
the rear end of a project. Table 5 summarises the
valuations referred to in this paper. In practice, a
more wide-ranging set of scenarios and valuations
would, undoubtedly, be used. Some of these might
be based upon subjective probability analysis applied
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
REAL OPTIONS
to various scenarios, for example, a probability of 20
per cent might be associated with scenario #1 in Table
5, a 55 per cent weighting with scenario #3, a 20 per
cent weight given to scenario #5 and a 5 per cent
probability for complete failure of the firm. Such an
approach would produce a bottom line value per
share of $17.275.
Further refinements to our sensitivity analysis might
also be incorporated into the valuation process. For
example, we have maintained the level of R&D
expenditure at a level of 36 per cent of sales. This
may be viewed as unduly high. We would defend
this as, possibly, being appropriate for the period
during which the real option perpetuates. However,
this may be too high a level thereafter. If we assume,
for scenario #3 in Table 5, that R&D could be cut to
26 per cent of sales from year 10 onwards (that is,
shortly after the real option runs out in year 8) and
if we assume that forecast profit levels would not be
adversely affected thereafter, this would enhance
value per share by as much as $4.70. Clearly, the level
of R&D represents a critical factor in the valuation
of Netscape.
But, the most critical scenario would be to consider
the effects of a strong competitive entry into the
browser market. Building this effect into the equ-
ation, possibly via a subjective probability being put
on the valuation with this scenario, would add sig-
nificant information. Depending upon the size of the
probability and timing of entry, this scenario may
reduce Netscape valuation to below $14 per share or,
even, to zero. Were Netscape only to achieve free
cash flows as in our defensive base case from the flo-
tation date out to 2003 — with nothing thereafter —
the firm would be worth around $2 per share.
In circumstances where an unprotected first-mover
521
REAL OPTIONS
Table 5 Netscape Valuation Summary
Scenario #
1 Defensive base case
2a Defensive base case plus ROV
with high trajectorya
2b Defensive base case plus ROV with low trajectory
3a Defensive base case plus ROV
with high trajectorya
3b Defensive base case plus ROV
with low trajectory
4 Defensive base case plus ROV
with low trajectory
5 Defensive base case plus ROV
with low trajectory
a
We have little confidence in the high trajectory figures
advantage is accompanied by low barriers to entry,
our advice does not embrace real options analysis. So
frequently is this the case with first-mover advantage
in a competitive industry that the analyst might well
be advised to stick with the basic DCF valuation.
Damodaran (2002) counsels against using real
options in anything but a sparing way. He warns that
opportunities are not always options and suggests
that ‘for opportunities to become valuable options,
you need some degree of exclusivity for the firm in
question — this can come from legal restrictions on
competition or a significant competitive edge’.
Empirical evidence also suggests caution in estimat-
ing the magnitude of t. Fuller et al. (1993) imply this
in a fascinating study of US companies. Annually,
from 1973 to 1990, they formed five portfolios of US
equity stocks. Their portfolios consisted of stocks
with the highest price earnings (P/E) ratios through
to lowest P/E ratios. Of course, highest P/E is the
same as saying lowest E/P (or earnings yield). The
researchers then observed the relative rates of growth
in earnings per share over the next eight years. Their
major conclusion, that differences in earnings growth
had virtually disappeared, by year eight, is borne out
in Figure 4. Similar mean reverting behaviour at the
level of accounting rate of return on equity has been
observed by Penman (1991) and Bernard (1994).
Although we have drawn on only one case study in
this paper, the lesson should be clear — namely that
using real options valuation with high values of t
must be underpinned by substantial and sustainable
barriers to entry. The mere possession of an unpro-
tected first-mover advantage suggests valuation
using traditional discounted cash flow methods.
Without significant barriers to entry, new competi-
tors can quickly be expected to emerge and appropri-
ate excess returns from the protagonist firm. Where
t is relatively small, the conclusion that valuation can
be left to DCF (without the reinforcement of ROV)
is inevitable.
522
Value per share
$15
t (yr) σ(%)
20 60 28
20 60 25
8 125 29
8 125 18–19
10 100 20
10 125 20–21
We have limited the use of hindsight in our real
options valuation exercise for Netscape since this
would clearly introduce inadmissible evidence given
our ex ante perspective. But, on this point, it may now
be appropriate to look back at actual outturns.
What Happened?
Netscape did issue 5 million new shares at $28 each
and it was a successful issue with new money coming
into the company as planned. Over the course of the
first day’s trading, Netscape stock touched $74 before
1
settling at $58 at the close, valuing the company at
4
$2.2 bn. In the aftermarket, the stock rose to $87 but
fell back, by 1997, towards the offer price. Its quar-
terly results following flotation are summarised in
Table 6; these show the firm thriving at the revenue
level. But note that net income is somewhat inconsist-
ent, with significant setbacks. It should also be men-
tioned that the net income per share figure is affected
by stock splits subsequent to the IPO. Table 6 also
indicates that our volatility figure of 125 per cent
looks too low. But our estimated net income in 1998
is not too far out versus reality. Note that compari-
sons between Tables 4 and 6 are problematical since
the former is a defensive base case without upside
optionality built in whereas the latter table includes
the effects of exercising upside real options.
On 28 November 1998, America Online Inc (AOL)
offered to acquire Netscape for AOL stock valued at
$4.2 billion, over four times the IPO value. The offer
was completed in Spring of 1999. The acquisition of
Netscape by AOL was financed 100 per cent by the
issue of new AOL shares. In November 1998, AOL
shares traded at the equivalent of $24 per share. By
Spring 1999, AOL’s common stock had risen to the
equivalent of $90 per share. But, at the time of writing
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
 REAL OPTIONS

Figure 4 The Value of t. How Long is Long? (Source: Fuller, R. et al. (1993)

Table 6 Netscape’s Results — Flotation To Acquisition

Revenue (mn$) Net Income (mn$)a Net Income Per Share ($)

1995 Q2b 11.9 (1.6) (0.05)

Q3 23.3 0.2 0.00
Q4 41.6 0.5 0.01
1996 Q1 56.1 3.6 0.04
Q2 75.0 0.9 0.01
Q3 100.0 7.7 0.09
Q4 115.2 8.8 0.10
1997 Q1 120.2 7.9 0.09
Q2 135.2 (43.8) (0.49)
Q3 150.1 11.7 0.13
Q4 125.3 (88.3) (0.98)
1998 Q1 127.2 0.0 0.00
Q2 150.2 0.1 0.00
Q3 162.0 2.7 0.03
a
Net income includes one-off charges and expenses
b
From 1995 Q2 until 1997 Q4, the quarter ends on 31 March (Q1), 30 June (Q2), 30 September (Q3) and 31 December (Q4).
From 1998 Q1, the quarter ends on 30 April (Q1), 31 July (Q2), 31 October (Q3) and 1 January (Q4). The reported figures for
the first quarter of 1998 reflect results for the three months to 30 April 1998

(April, 2002), AOL’s share price (now AOL Time house. Although Navigator’s market share goes into
Warner) had fallen to around $20 per share. And the decline, Netscape stockholders do not do too badly. AOL
Netscape part of the business was under severe pro- buys the business for a sum that is still twice the ludicrous
price at which Netscape was floated.
fits pressure, following Microsoft’s move into its ter-
ritory. In 1996, Netscape commanded 80 per cent of
The Netscape story is racily related in Perkins and
the Web browser market: by the end of 2000, it was
Perkins (2001) and in Cassidy (2002). Both reinforce
Microsoft that held 80per cent of the market. Kay
the conclusions of our paper.
(2002) draws a telling metaphor:

Microsoft launches a browser, Internet Explorer, which With hindsight, because of its takeover, Netscape
does much the same as Navigator, is pre-installed and is was well worth the $28 issue price even though our
free. Netscape is dead in the water. It is trying to sell valuation needs the support of a really optimistic real
plumbing systems to someone who has bought a new-built options scenario to get near this price. We would not

European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002 523
REAL OPTIONS
have been buyers of Netscape stock at the IPO price.
We would have missed out on this opportunity
which turned out to be better than expected. But,
using the approach here, we would have missed a
lot of dud stocks too. In passing, reference is made
to the ethical conflict that would be present were the
advising investment bank to view a fair valuation of
Netscape equity to be between, say, $18 and $19 per
share but the price that investors were prepared to
pay, following the road show presentations,
appeared to be around $28 per share.7
No claim is made that the real options approach is
superior to traditional discounted cash flow valu-
ation. It is merely another way of looking at the valu-
ation problem. Correctly implemented, ROV and
DCF should yield similar results. Enhancing a DCF
base case with sensitivity analysis would be an
entirely reasonable way of valuing Netscape. Indeed,
having identified a relatively short t, we feel that it
is the preferred route to valuation. We deliberately
chose the real options approach not because it is
superior or more appropriate but to show how it
might be used in the valuation of equities. Using
basic valuation metrics, like forward P/E ratios, is,
of course, part of estimating a value for a firm. For
Netscape, the $14 per share price implies a forward
P/E, based on the defensive base case, of 13.4 times
estimated 2000 earnings and a ratio of 6.5 times 2002
earnings. The $28 flotation price implies respective
forward P/E ratios of 27.9 and 13.5, rather high given
our perspective from 1995. Possible other ratios used
to make valuation comparisons with similar busi-
nesses (if any) would be enterprise value to sales,
enterprise value to earnings before interest and tax,
value per subscriber — and a host of others too,
although we prefer the cash flow focus of DCF or
ROV. Indeed, to give such metrics as value per sub-
scriber (that is neither profit nor cash flow orientated)
prime billing, rather than using it as a weak subsidi-
ary indicator of value, is asking for problems. We
would reiterate that we prefer to specify a range of
potential value rather than homing in on a precise,
single figure, valuation.
Conclusions
During the stock market bubble which peaked in
2000, many commentators, who should have known
better, were calling for new valuation principles
which explained prevailing levels of share price —
an example of putting the cart before the horse, if
ever there was one. Perhaps it was at this time that
real options valuation gained its greatest popularity
to date, not necessarily as a stock market valuation
tool but as a potential reinforcement to DCF in capital
investment appraisal. It is our perception that ROV
has become tarred with the same brush as the
dot.com boom.
To conclude that ROV is another case of the
524
emperor’s new clothes would, in our opinion, be
short-sighted and wrong. In the wake of the stock
market bubble and the irrational exuberance that
seemed to impact high technology, it would be all
too easy to throw the real options baby out with the
dot.com bathwater. We would urge resistance of
this temptation.
We argue in this paper that ROV is not a revolution-
ary new technique that challenges traditional DCF,
but it is a refinement that complements incumbent
valuation methods. Whilst it is true that strong
potential competition within a particular business
segment can mean that ROV techniques do resemble
the emperor’s new clothes, there are numerous situ-
ations where real options exist and justify time spent
on their valuation. Where growth opportunities are
significant and where the firm has sufficiently strong
competitive advantages to enable it to scale-up its
operations to exploit upside potential, valuation with
real options may be appropriate.
Many company executives believe that their firms
possess an array of real options. This may be so and
strategic thinking may be enhanced by reference to
real options ideas. But the acid test is whether the
firm’s unbiased fundamental value of assets in place
based on a DCF valuation is equal to its stock market
value. Very often, this is near enough the case. But
when firms do posses a range of growth opport-
unities, market value may exceed the fundamental
value of assets in place. In such circumstances, the
difference is usually attributable to the present value
of growth opportunities, sometimes termed market-
imputed real option value. After adjusting for sur-
plus assets that the firm may posses (such as invest-
ments in other companies, cash deposits etc.) and
also for the value of debt that the company owes, the
value equations below would apply:
Fundamental value of assets in place +
Present value of growth opportunities =
Total fundamental value
Fundamental value of assets in place +
Market - imputed real option value =
Stock market value
Clearly, if markets were efficiently pricing stocks,
total fundamental value would be equal to stock mar-
ket value and market-imputed real options value
would be equal to the present value of growth
opportunities. In reality, there may be growth
opportunities that the directors are nurturing that
have not yet been communicated to financial mar-
kets, perhaps because of potential competitor
response were they to be made public. Furthermore,
financial markets do not always value stocks cor-
rectly and this is borne out by the increasing evidence
of deviation from efficient markets — for a succinct
overview see Arnold (2002).
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002

We use the example of Netscape to show how real
options might be employed to value a growth stock.
At the time of its IPO, Netscape essentially comprised
a large real option on its potential in the browser
market. We begin by suggesting the development of
a defensive base case scenario using DCF techniques.
On top of this, we superimpose a real option valu-
ation plus sensitivity analysis. Dealing with the input
values of t and σ is critical and benchmarks are
advanced in this paper — on the issue of the magni-
tude of these two variables, we counsel sobriety.
Where t is relatively small, there is virtually no case
to be made for using ROV.
Unlike Schwartz and Moon (2000), who conclude that
‘given high enough growth rates of revenue, the
value of internet stocks may be rational’, we reach a
very different view in the case of Netscape. Using
reasonable inputs into the valuation equation
(although our margins may be a little high), we can
see no way in which the valuation of the firm was
anything near rational at the time of the IPO. Like
Cooper et al. (2001), who identify massive increments
to firm value by the mere addition of the suffix ‘.com’
to their names in 1998 and 1999, we believe that our
evidence is indicative of stock market irrationality.
Confirming this view, Taffler and Tuckett (2002) add
interesting behavioural insights.
Some of the lack of discipline in valuing high growth
stocks can be avoided by the routine of attempting
to reverse engineer the implied value of t given
benchmark estimates of volatility, and/or vice-versa.
Without it being explicitly the case, the fall to earth
of the dot.com boomers probably involved market
participants estimating the length of time needed for
excess returns to be achieved in business segments
which possessed very low barriers to entry.
Valuation of stocks as stars plus their subsequent cor-
rection following more rational views of volatility
and time may be at the heart of why value stocks
(variously defined as low P/E, high dividend yield,
high cash flow per share, or low market value to
book value) have consistently outperformed glamour
stocks (defined as either high P/E, low dividend
yield, low cash flow per share, or high market value
to book value) in equity markets — see Lakonishok
et al. (1994) and Fama and French (1995), amongst
others. As both of these stock types regress towards
the mean, undervaluation and overvaluation are
eliminated creating the observed anomaly.
In appropriate circumstances, ROV can logically be
used to complement DCF valuation. For most compa-
nies, DCF copes perfectly well, but in a few circum-
stances, ROV may be invoked to reinforce valuation.
We are not suggesting that ROV is superior to DCF.
Neither are we suggesting that traditional DCF valu-
ation plus sensitivity analysis fails to perform
adequately. However, getting to grips with valuation
often involves calculations using more than one
European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002
REAL OPTIONS
methodology. ROV, in some select circumstances, is
an adjunct to more basic methods. Correctly and
sparingly utilised, it has a place in the armoury of the
equity investment analyst — especially in identifying
overvalued, high growth stocks.
Notes
1. We restrict our real options analysis to the straight call
option valuation with a constant variance through time.
2. The figure of 81 per cent is based on the average of cash
costs to contribution. A case could be made for the use of
the marginal ratio because exercising an option to increase
revenues implies incurring marginal cost to achieve mar-
ginal contribution. Clearly, the cash flow analysis that is
available from outside of the firm does not go this deep.
Nevertheless, maybe sensitivity analysis might be under-
taken using figures for proxy firms — although identifi-
cation of the proxy firm might be difficult.
3. We assume that the upside call option potential erodes lin-
early from time 0 to time t, effectively a reduction of t ⫺1 per
year. In market segments characterised by sudden shocks,
this may be less than realistic — see note 5 on this point.
Valuations with other rates of erosion are easily modelled.
4. It should be noted that reverse engineering of these figures
is possible. For example, given a time factor of 8 years, we
might seek to solve the equation for the volatility factor
that would justify a price per share of $28.
5. Readers may suspect that this represents the authors’ pre-
ferred view of the situation. Since the volatility factor of
125 per cent for Internet stocks has only emerged as a
benchmark well after the Netscape IPO, an element of
hindsight cannot be denied.
6. This value results from using the dividend-paying version
of the Black and Scholes model. We might use the non divi-
dend-paying model, implying a sudden loss of option value
at year t rather than a gradual loss. This would not be
unrealistic in the discontinuous world of high technology.
Were we to do this, using a figure of 8 years for t and 125
per cent for volatility, and also employing the low trajectory
approach, the value per share of Netscape comes out at $23.
7. Such ethical issues are being publicly aired as a result of
the investigation by Eliot Spitzer, the New York attorney-
general, into some of the practices of US investment banks,
notably Merrill Lynch, at the time of the boom in
dot.com stocks.
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reference 201-031-1

ADRIAN BUCKLEY, KALUN TSE, University

Cranfield School of Manage-
ment, Cranfield University,
Bedford, MK43 OAL, UK.
E-mail:
adrian.buckley@cranfield
.ac.uk.
Dr Adrian Buckley is Pro-
fessor at Cranfield School of
Management and Visiting
Professor at the Free Uni-
versity, Amsterdam. His teaching and research inter-
ests include international finance and real operating
options. He is author of a number of finance textbooks,
of which Multinational Finance, now in its fourth edi-
tion, is the most well known.
of Nyenrode, Straatweg 25,
3621 BG Breukelen, The
Netherlands. E-mail:
k.tse@nyenrode.nl.
Dr Kalun Tse holds a joint
appointment as Professor of
Finance at Nyenrode Uni-
versity, and at the China
Europe International Busi-
ness School (CEIBS) in
Shanghai. He serves as an advisor to government bodies
and international agencies and has conducted con-
sultancy assignments for financial institutions and
companies in Europe and the Far East.

HERBERT RIJKEN, Free HANS

University, Amsterdam, De
Boelelaan 1105, 1081 HV
Amsterdam, The Nether-
lands. E-mail: hrijken@econ
.vu.nl.
Dr Herbert Rijken is Associ-
ate Professor of Finance at
the Free University,
Amsterdam. His research
interests are in the area of
corporate finance and asset pricing theories and their
application in the real world.
EIJGENHUIJSEN, Free
University, Amsterdam, De
Boelelaan 1105, 1081 HV
Amsterdam, The Nether-
lands. E-mail: h.g.eijgenhu
ijsen@wxs.nl.
Dr Hans Eijgenhuijsen is
Professor of Finance at the
Faculty of Economics and
Business Administration of
the Free University, Amsterdam. His interests are in
investment and finance as reflected by his board mem-
bership of the Advisory Committee of the Euronext
Stock Exchange, Amsterdam, the Investment Advisory
Council of KLM Pension Funds and the Accreditation
Committee of the Dutch Securities Institute.

526 European Management Journal Vol. 20, No. 5, pp. 512–526, October 2002