Tuesday, October 22, 2013 6:19:58 PM
Present value calculations are ubiquitous in finance. But the average of stochastic inputs cannot be used to calculate the average present value because the formula is non-linear. This is due to the so-called Jensen inequality. We need to know the the probability distribution of the inputs in order to calculate the mean present value. Monte Carlo simulation allows us to simulate numerous outcomes of a mathematical model so as to estimate that probability distribution.
In finance, the Monte Carlo method is used to simulate the various sources of uncertainty that affect the value of an investment, and to then calculate a representative value given these possible values of the underlying inputs. ("Covering all conceivable real world contingencies in proportion to their likelihood.") In terms of financial theory, this, essentially, is an application of risk neutral valuation. The method of risk-neutral pricing should be considered as many other useful computational tools — convenient and powerful, even if seemingly artificial.
You stated: "you never factored in the risk of a loss in the trial". If you are referring to the new Activision v. Worlds lawsuit, yes, you are correct. I believe that new lawsuit will not harm Worlds' stock price in any way. If you are referring to the Worlds v. Activision lawsuit, I do consider the risk of a loss, as Worlds receives $0 if they lose that case.
You also stated: "The company only has 5mil in liabilities from what I see." It's my understanding, that according to Worlds' financial statements (in the footnotes), the equivalent of $40M NOL is on the books. In either case ($5M or $40M), it only effects the tax calculation on gains, and is relatively insignificant in the big picture of trying to value WDDD.
Bottom line:
Monte Carlo methods are just another tool. A "convenient and powerful" tool at that.
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