Real options valuation


Real options valuation, also often termed real options analysis, applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively.
Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security. A further distinction is that option holders here, i.e. management, can directly influence the value of the option's underlying project; whereas this is not a consideration as regards the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management also have to create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task. Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.
Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to "real-life" decisions. For example, R&D managers can use Real Options Valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects. A non business example might be the decision to join the work force, or rather, to forgo several years of income to attend graduate school. It, thus, forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation. This extension of real options to real-world projects often requires customized decision support systems, because otherwise the complex compound real options will become too intractable to handle.

Types of real options

The flexibility available to management – i.e. the actual "real options" – generically, will relate to project size, project timing, and the operation of the project once established. In all cases, any upfront expenditure related to this flexibility is the option premium. Real options are also commonly applied to stock valuation - see Business valuation #Option pricing approaches - as well as to various other [|"Applications" referenced below].

Options relating to project size

Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.
Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant project is valuable, and constitutes optionality. Growth options are perhaps the most generic in this category – these entail the option to exercise only those projects that appear to be profitable at the time of initiation.
Management may have flexibility relating to the product produced and /or the process used in manufacture. This flexibility constitutes optionality.
Given the above, it is clear that there is an analogy between real options and financial options, and we would therefore expect options-based modelling and analysis to be applied here. At the same time, it is nevertheless important to understand why the more standard valuation techniques may not be applicable for ROV.

Applicability of standard techniques

ROV is often contrasted with more standard techniques of capital budgeting, such as discounted cash flow analysis / net present value.
Under this "standard" NPV approach, future expected cash flows are present valued under the at a discount rate that reflects the embedded risk in the project; see CAPM, APT, WACC.
Here, only the expected cash flows are considered, and the "flexibility" to alter corporate strategy in view of actual market realizations is "ignored"; see below as well as Corporate finance#Valuing flexibility.
The NPV framework assumes that management is "passive" with regard to their Capital Investment once committed.
Some analysts account for this uncertainty by
adjusting the discount rate, e.g. by increasing the cost of capital,
or adjusting the cash flows, e.g. using certainty equivalents,
or applying "haircuts" to the forecast numbers,
or via probability-weighting these as in rNPV.

Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.
By contrast, ROV assumes that management is "active" and can "continuously" respond to market changes. Real options consider "all" scenarios and indicate the best corporate action in each of these contingent events. Because management adapts to each negative outcome by decreasing its exposure and to positive scenarios by scaling up, the firm benefits from uncertainty in the underlying market, achieving a lower variability of profits than under the commitment/NPV stance. The contingent nature of future profits in real option models is captured by employing the techniques developed for financial options in the literature on contingent claims analysis. Here the approach, known as risk-neutral valuation, consists in, while discounting at the risk-free rate. This technique is also known as the "martingale" approach, and uses a risk-neutral measure. For technical considerations here, see below.
Given these different treatments, the real options value of a project is typically higher than the NPV – and the difference will be most marked in projects with major flexibility, contingency, and volatility. As for financial options higher volatility of the underlying leads to higher value. Part of the criticism of Real Options Valuation in practice and academe stems from the generally higher values for underlying assets these functions generate. However, studies have shown that these models are reliable estimators of underlying asset value, when input values are properly identified.

Options based valuation

Although there is much similarity between the modelling of real options and financial options, ROV is distinguished from the latter, in that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, coupled with management's ability to respond to the evolution of these parameters. It is the combined effect of these that makes ROV technically more challenging than its alternatives.
When valuing the real option, the analyst must therefore consider the inputs to the valuation, the valuation method employed, and whether any technical limitations may apply. Conceptually, valuing a real option looks at the premium between inflows and outlays for a particular project. Inputs to the value of a real option are each affected by the terms of business, and external environmental factors that a project exists in. Terms of business as information regarding ownership, data collection costs, and patents, are formed in relation to political, environmental, socio-cultural, technological, environmental and legal factors that affect an industry. Just as terms of business are affected by external environmental factors, these same circumstances affect the volatility of returns, as well as the discount rate. Furthermore, the external environmental influences that affect an industry affect projections on expected inflows and outlays.

Valuation inputs

Given the similarity in valuation approach, the inputs required for modelling the real option correspond, generically, to those required for a financial option valuation. The specific application, though, is as follows:
The valuation methods usually employed, likewise, are adapted from techniques developed for valuing financial options. Note though that, in general, while most "real" problems allow for American style exercise at any point in the project's life and are impacted by multiple underlying variables, the standard methods are limited either with regard to dimensionality, to early exercise, or to both. In selecting a model, therefore, analysts must make a trade off between these considerations; see Option #Model implementation. The model must also be flexible enough to allow for the relevant decision rule to be coded appropriately at each decision point.
Various other methods, aimed mainly at s, have been developed for real option valuation. These typically use cash-flow scenarios for the projection of the future pay-off distribution, and are not based on restricting assumptions similar to those that underlie the closed form solutions discussed. The most recent additions include the Datar–Mathews method and the fuzzy pay-off method.

Limitations

The relevance of Real options, even as a thought framework, may be limited due to market, organizational and / or technical considerations. When the framework is employed, therefore, the analyst must first ensure that ROV is relevant to the project in question. These considerations are as follows.

Market characteristics

As discussed above, the market and environment underlying the project must be one where "change is most evident", and the "source, trends and evolution" in product demand and supply, create the "flexibility, contingency, and volatility"
which result in optionality. Without this, the NPV framework would be more relevant.

Organizational considerations

Real options are "particularly important for businesses with a few key characteristics", and may be less relevant otherwise. In overview, it is important to consider the following in determining that the RO framework is applicable:
  1. Corporate strategy has to be adaptive to contingent events. Some corporations face organizational rigidities and are unable to react to market changes; in this case, the NPV approach is appropriate.
  2. Practically, the business must be positioned such that it has appropriate information flow, and opportunities to act. This will often be a market leader and / or a firm enjoying economies of scale and scope.
  3. Management must understand options, be able to identify and create them, and appropriately exercise them. This contrasts with business leaders focused on maintaining the status quo and / or near-term accounting earnings.
  4. The financial position of the business must be such that it has the ability to fund the project as, and when, required ; see Financial statement analysis. Management must, correspondingly, have appropriate access to this capital.
  5. Management must be in the position to exercise, in so far as some real options are proprietary while others are shared.

    Technical considerations

Limitations as to the use of these models arise due to the contrast between Real Options and financial options, for which these were originally developed. The main difference is that the underlying is often not tradable – e.g. the factory owner cannot easily sell the factory upon which he has the option. Additionally, the real option itself may also not be tradeable – e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision. Even where a market exists – for the underlying or for the option – in most cases there is limited market liquidity. Finally, even if the firm can actively adapt to market changes, it remains to determine the right paradigm to discount future claims
The difficulties, are then:
  1. As above, data issues arise as far as estimating key model inputs. Here, since the value or price of the underlying cannot be observed, there will always be some uncertainty as to its value and volatility.
  2. It is often difficult to capture the rules relating to exercise, and consequent actions by management. Further, a project may have a portfolio of embedded real options, some of which may be mutually exclusive.
  3. Theoretical difficulties, which are more serious, may also arise.
These issues are addressed via several interrelated assumptions:
  1. As discussed above, the data issues are usually addressed using a simulation of the project, or a listed proxy. Various new methods – see for example those described above – also address these issues.
  2. Also as above, specific exercise rules can often be accommodated by coding these in a bespoke binomial tree; see:.
  3. The theoretical issues:

    History

Whereas business managers have been making capital investment decisions for centuries, the term "real option" is relatively new, and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977. In 1930, Irving Fisher wrote explicitly of the "options" available to a business owner. The description of such opportunities as "real options", however, followed on the development of analytical techniques for financial options, such as Black–Scholes in 1973. As such, the term "real option" is closely tied to these option methods.
Real options are today an active field of academic research. Professor Lenos Trigeorgis has been a leading name for many years, publishing several influential books and academic articles. Other pioneering academics in the field include Professors Michael Brennan, Eduardo Schwartz, , , , Avinash Dixit and Robert Pindyck. An academic conference on real options is organized yearly.
Amongst others, the concept was "popularized" by Michael J. Mauboussin, then chief U.S. investment strategist for Credit Suisse First Boston. He uses real options to explain the gap between how the stock market prices some businesses and the "intrinsic value" for those businesses. Trigeorgis also has broadened exposure to real options through layman articles in publications such as The Wall Street Journal. This popularization is such that ROV is now a standard offering in postgraduate finance degrees, and often, even in MBA curricula at many Business Schools.
Recently, real options have been employed in business strategy, both for valuation purposes and as a conceptual framework. The idea of treating strategic investments as options was popularized by Timothy Luehrman in two HBR articles: "In financial terms, a business strategy is much more like a series of options, than a series of static cash flows". Investment opportunities are plotted in an "option space" with dimensions "volatility" & value-to-cost.
Luehrman also co-authored with William Teichner a Harvard Business School case study, Arundel Partners: The Sequel Project, in 1992, which may have been the first business school case study to teach ROV. Reflecting the "mainstreaming" of ROV, Professor Robert C. Merton discussed the essential points of Arundel in his Nobel Prize Lecture in 1997. Arundel involves a group of investors that is considering acquiring the sequel rights to a portfolio of yet-to-be released feature films. In particular, the investors must determine the value of the sequel rights before any of the first films are produced. Here, the investors face two main choices. They can produce an original movie and sequel at the same time or they can wait to decide on a sequel after the original film is released. The second approach, he states, provides the option not to make a sequel in the event the original movie is not successful. This real option has economic worth and can be valued monetarily using an option-pricing model. See Option.

Theory