Corporate executives identify strongly with the intuition behind real options, whether it’s keeping the company’s strategy and operations flexible or investing in future growth opportunities. But often the connection ends there. Understanding that we can view an opportunity as a real option raises questions such as how much should the company spend on acquiring and exercising real options, and what might the real options be worth to our investors and strategic partners. We must ask ourselves, is there a way to value these real options sensibly and consistently?
The first step to examining how to value a real option is to appreciate how not to value it. Standard discounted cash flow (DCF) analysis does a poor job of capturing the cash flows associated with a real option and its risk, which means that the discount rate used is typically inappropriate.
Different techniques offer better analysis. An intuitive approach to valuing options is the binomial model. We can map out different scenarios for how the underlying asset value evolves over time so we can then more accurately assess the option cash flows. We then account for the risk by adjusting probabilities for the scenarios rather than adjusting the discount rate based on risk. Another technique is for us to use the Black-Scholes formula, which follows similar principles and is relatively quick to use—thus frequently employed in practice—but it is more of a black box approach.
A classic real option opportunity is an investment in an option to develop a vacant piece of land. With a defined maturity and data at your disposal to estimate rental rates and fluctuations in property values, you can value the option to develop using the binomial option pricing and Black-Scholes methods. By calculating both methods, you can examine the potential strengths and shortcomings of each. You can also better determine what drives the value of real options to gain a better intuition for how to create more value through strategies for real options.
How can you make sure you are investing wisely in real options and optimizing them to create more value for your company? The Accenture Academy course Valuing Real Options
guides you through common real option valuation techniques to improve your evaluation accuracy for real options and develop a stronger sense of what drives their value.