About Real Options
Real Options represents a relatively new state-of-the-art framework for the valuation and management of strategic investments.
Companies create shareholder value by identifying, managing and exercising Real Options associated with their investment portfolio. Real Options enables corporate decision-makers to leverage uncertainty and limit downside risk by applying financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project.
Why use real options and other advanced techniques to value strategic investment decisions?
Traditional valuation methods fall short of what managers really need. Discounted cash flow (DCF) based net present value (NPV) methods are most commonly used by managers to justify investments but are counter-intuitive.
1. Traditional NPV methods assume that cash flow projections are 100% certain – in reality, projections are far from certain and uncertainty increases over time!
2. Investment decisions are flexible - in their staging, timing, intensity and sequence.
In reality, managers make decision based on their experience and intuition thereby overriding traditional financial analysis.
Real Options, on the other hand, capture the value of management flexibility - they hedge against the risk of pre-committing to investments in the event that actual cash flows turn out to be lower than projected, as well as capturing the ability to exploit opportunities to increase returns when better information becomes available. This leads to a more accurate assessment of the value of strategic investments and a better way of communicating the rationale behind that value.
Management can use can use these techniques to:
1. Identify optimal investment decision pathways or projects given highly uncertain business conditions
2. Value each pathway in terms of financial viability and feasibility
3. Prioritize pathways or projects based on qualitative and quantitative metrics
4. Time the effective execution of investments and find the optimal trigger values
5. Identify new strategic decision pathways to exploit future opportunities.
There are many types of real options available to management. For example:
A. Options to abandon/sell
1. When the residual value of an asset falls below its liquidation value sell
2. Abandon R&D projects that do not meet hurdle criteria at any given time to avoid allocating additional capital to a dead-end project
3. Sell/license patent to another entity with which patent holder has a contract
B. Options to defer/switch
1. Temporarily defer further investments until uncertainties clear up (from a technology, business or regulatory stand point)
2. Switch to alternative use if alternative can yield greater returns
C. Options to expand
1. Acquire a competitor to increase free cash flow/add capacity given the right market conditions
2. Enter new market/introduce new product.
When should Real Options Analysis be used to value investment decisions?
1. There is a high degree of uncertainty regarding future outcomes e.g. cash flows are highly uncertain and are a long way from materializing due to, for example, long research and development timelines
2. Traditional NPV analysis yields negative or breakeven results but intuition says that management has options that can enhance project value
3. Management has put in place mechanisms to ensure optimal execution of these options options have no value if they are not executed before they expire.