Ellsberg Paradox and Option value of investing

 Ellsberg Paradox 

People prefer to take risks in situations where the odds are known, rather than a scenario where the odds are unknown - even when the latter scenario has the guarantee of a positive outcome (its just that the magnitude of the outcome is unknown). Its often used to evaluate how people have an aversion to ambiguity. 

Where do the traditional financial tools fall short ? 

In traditional investing, the most common financial tool for valuing a company is DCF model (discounted cash flow model). Under this methodology, investors attempt to accurately model out the discrete financial metrics of a company over a finite period of time, and discount the cash flow generated to determine the appropriate valuation for a company.

The issue is though that in real investing, businesses have embedded options which have unknown outcomes everywhere. DCF is terrible at valuing these businesses which have both : 1. uncertain payoff magnitude and 2. uncertain timing as to when it will occur. Examples of such options : 

• Amazon is able to extend its dominance on one ecommerce category(books) to multiple categories
• Amazon is able to extend its dominance in ecommerce to build the largest retail search engine in the world and draw advertising dollars
• Google is able to leverage its technology prowess in building scalable and reliable search infrastructure to build Google Cloud and democratize building distributed systems technology. Same for AWS and Azure
• Apple launching Wearables segment (Watch, airpods, etc) using its expertise in building iphones

For each of these successful options, there are multiple failed investments like Fire Phone, Google's communication apps, etc. However, in net all these embedded options have generated multiples of shareholder value which would not have been able to be correctly valued through DCF. 

This paper articulates this concept in detail : Get real, using real options in security analysis

This diagram illustrates how the valuation breakdown of such companies progresses

Some of the parameters to evaluate such businesses are

Management 

• Superior capital allocation 
• Access to cheap capital from markets or through high profit margin businesses
• Execution track record
• Ability attract top talent in the industry

Business

• Strong moat
• Economies of scale
• Economies of scope

Evolving markets

• New trends of user behavior and patterns
• Uncertainty

No wonder FAANGs check several of the above boxes and continue to generate superior returns for their shareholders. 

References

1. Hayden Capital Quarterly Letter Q3 2020

2. Get real, using real options in security analysis