Because real options are a relatively recent development in the area of project valuation, there is a general lack of familiarity with the topic among many practitioners. This lack of familiarity has sometimes resulted in misconceptions about the purpose, theoretical basis, and scope of application of real option valuation. I address a few of the common misconceptions here:
“Real option valuation is just a way to make bad projects look good.”
This notion probably stems from the fact that option value, when excluding any premium, cannot be negative. Since an option is a right, and not an obligation, any option that would produce a negative payoff is simply never exercised. Therefore, real option values are never less than the deterministic net present value, unless there is a cost factored in for acquiring project flexibility. As a result, a manager who is unfamiliar with the principles of option valuation might be skeptical to see consistently higher values from real options analysis, relative to those from conventional discounted cash flow valuation. However, when project valuations are higher under a real options analysis, it does not signal a disingenuous valuation; instead, it simply indicates that the techniques employed are able to capture sources of value that traditional analyses cannot.
“It is only useful to conduct real option valuations for marginal projects.”
As discussed in a previous paper written for the Graziadio Business Report, a real option valuation can be more complicated than a standard discounted cash-flow valuation. The analyst must first be able to build a stochastic model of project value, and then develop an algorithm to model optimal decision making during the project. These may not be trivial tasks for many projects, even when using the decision tree-based approach we discuss in our paper. This might lead to questions about whether such analyses are worthwhile, especially if a standard analysis indicates that a project has a large positive net present value and high rate of return. Following the points made above, it would seem that any options would only add to the already positive project value. However, it is often important, especially when selecting among many investment candidates in a portfolio or when transacting with partners or in acquisition/divestiture markets, to be able to accurately assess a project’s value. The best way to accomplish this is to conduct an analysis that accounts for all sources of value.
“Real option valuation is not consistent with the principles of standard finance.”
The “consolidated” approach discussed in our paper, which was developed by Copeland and Antikarov, allows complex problems with multiple underlying uncertainties to be modeled in terms of a single variable—project value. This approach appears to be somewhat different than what is described in the classical Finance literature, which has led to some skepticism about the validity of the approach. One particular issue is the possibility of combining a “market-priced” uncertainty, such as commodity price, with a “private, firm-specific” uncertainty, such as facility operating cost. A close inspection shows, however, that there is really no difference between the way uncertainties are accounted for in the consolidated approach as compared to the standard finance approach; before consolidating the uncertainties in a project value simulation, market information should be used to specify the stochastic processes for any market uncertainties (such as price in Figure 1 in the paper) and the firm’s estimates should be used to specify the stochastic processes for any firm-specific private uncertainties (such as production cost in Figure 1). Moreover, many real projects are far too complex to be analyzed if each underlying uncertainty is explicitly modeled. This is the breakthrough that Copeland and Antikarov achieved in developing the consolidated approach to modeling project uncertainty.
See Hahn’s extended article in the Graziadio Business Report here. For additional details and discussion of these issues, refer to Brandao, Dyer and Hahn[i], [ii] and Smith[iii] in the reading list below.
[i] Brandao, L., Dyer, J., and Hahn, J., “Using Binomial Decision Trees to Solve Real-Option Valuation Problems”, Decision Analysis, 2 (2005b), 69-88.
[ii] Brandao, L., Dyer, J., and Hahn, J., “Response to Comments on Brandao, et al (2005)”, Decision Analysis, 2 (2005a), 103-105.
[iii] Smith, J., “Alternative Approaches for Solving Real Options Problems”, Decision Analysis, 2 (2005), 89-102.