What are Real Options?
A “real option” is the right, but not the obligation, to make a strategic investment decision (expand, scale back, abandon, delay, switch, etc.) relative to an underlying asset that is not a financially traded security (a piece of equipment, a production facility, a business, a commercial contract, a phased R&D project, intellectual property like a patent or trademark, employees, or any other business asset).
Real options represent the flexibility in decision making that impact financial value typically available in some form, at some point in time, with many strategic business assets. These options can exist individually, in sequence or in combination.
What is the value of Real Options Analysis?
Individuals and organizations should look at real options from three key perspectives:
- as a strategic planning and analysis thinking framework,
- as a risk assessment and management methodology,
- as an investment analysis tool.
Much of the benefit of real options analysis is in developing new and/or alternate approaches to actively manage assets utilizing flexibility and in better recognizing and taking advantage of existing investment flexibility. This real options « thinking » leads to increased opportunities to take advantage of upside market potential and mitigate downside risks. Real option strategies put into action, simultaneously increase expected value, as well, as improve the risk profile of investment cash flows.
The traditional discounted cash flow methodologies (typically NPV and/or IRR decision criteria based) used by the vast majority of corporate practitioners are based on a static set of input values (usually “best guess”) and assume passive management over the life of the investment. When valuing flexibility the significant determinants of value are the degree of uncertainty in the anticipated returns on the underlying asset (“volatility”), the cost/benefit of the implementing the option (“exercise or strike price”) and the amount of time available before the option opportunity expires.
How can Real Options be evaluated?
Real options can be evaluated by a variety of techniques. In many cases, organizations have avoided consideration or failed in attempts to apply real options « thinking » because it requires application of complex and difficult to understand and explain option formulas (like the Black & Scholes equation). In fact, option pricing formulas are rarely the best approach to addressing real options analysis. Generally practitioners apply binomial tree methods associated to decision trees to real option problems. Such techniques are applicable to a wider range of decisions, much more intuitive, visual, easier to explain and more flexible than formula approaches.
What is the state of Real Options application?
Real options analysis is a relatively new methodology compared to traditional discounted cash flow methods. The oil & gas, mining and electric utility industries were the earliest adopters and remain significant users of real options methodology. This developed out of the major capital requirements and long investment lead times, high levels of uncertainty, and strong financial links to actively traded commodities inherent in these industries. Subsequent industry adopters include including pharmaceutical, manufacturing, high tech, and communications. Many pharmaceutical and technology industry applications have successfully looked to real options analysis to support development of optimal strategies for high risk and capital intensive staged investments.