Real Options Valuation
Real Options Valuation captures the value of strategic decision making, allowing for a more accurate Business Valuation. It is also crucial for Contract Design and Risk Analysis.
Real Options Valuation helps decision makers make better decisions, and develop stronger, more flexible, and more profitable businesses.Our models of Real Options Valuation build on financial data analysis and market research for a deeper customization to the problem, thus accurately valuating the options of decision makers, determining the best options now and the value of Real Options in the future.
What is a Real Option?
A Real Option is the right – but not the obligation – to undertake a business decision now or in the future. Real Options Valuation offers the only framework that valuates the flexibility inherent to Real Options: it valuates the ability to change the business route over time.
A Real Option has value whenever three conditions – common to almost all strategic and financial decisions – are present:
- Flexibility: the ability to change the business route over time. By flexibility, we mean that decision makers can adapt the scale of scope of their businesses. By flexibility, we also mean that decisions can be delayed to wait for further information; decision makers are not forced to make a “now or never” decision.
- Uncertainty: the value of a project cannot be fully predicted. By uncertainty, we mean that future cash flows, investment costs, or any other relevant value driver are impossible to fully predict. There is always the possibility that new events change the state of the economy and the value of businesses.
- Irreversibility: most decisions have no turning back. By irreversibility, we mean that decisions imply sunk costs. For example, once a contract is signed or an investment is made, it is generally impossible to terminate a contract without a penalty as well as to fully recover the investment.
Simple Examples of Applications of Real Options Valuation
We offer three simple applied examples of Real Options Valuation. These examples show the logic of Real Options Valuation and contrast it with the logic of traditional capital budgeting techniques.
We show how the investment decision depends on the value of waiting for further information.
We show how the Net Present Value (NPV) creates inaccurate information in the case of staged investment. We show that a negative NPV does not necessarily imply that the firm should not invest. And we show that a positive NPV does not necessarily imply that the firm should invest in full capacity.
We show how the Net Present Value may induce firms to disinvest potentially profitable businesses.