Real Options in Practice

 

Real Options Valuation (ROV) is used by a significant share of the Fortune 1000 firms. In a survey of 2007, it is reported that 14.3% of the firms in the sample use this method. It is also reported that 43.5% of the firms that did not employ ROV at the time of the survey, were seriously considering adopting ROV in the near future.

 

Here, we try to answer the following question: Why is not ROV already a common practice? The usual reason is that ROV is a complex and demanding tool, and thus, for ROV to be efficiently employed it requires effort and resources. This is the reason why Watson & Noble exists.

 

ROV is a powerful tool for strategic decision making and for Business Valuation. But to be properly employed and customized to each problem and situation, it requires the expertise the members of Watson & Noble have built for many years. For that matter, we at Watson & Noble offer our clients the best tools for strategic and business valuation, and we do so in an intuitive manner so that our clients get the most of the tool without any the drawbacks of its complexity. We create value by employing the complex tools of ROV and let our client enjoy its powerful accuracy and flexibility in an intuitive manner.

 

Another reason for managers not to use ROV is the myth that it promotes too much risk taking. This is not accurate for a simple reason: ROV, if properly applied, is a much more accurate decision tool than any other method, as the Net Present Value (NPV), or other simpler methods as the Payback Period. This is explored in How it Works and in Simple Examples.

 

ROV does not promote too much risk taking; it rather promotes better decision making. In some cases, the optimal decision suggested by ROV is to invest even without a positive NPV. In that sense, ROV promotes investment, but not necessarily more risk taking. In practice, managers already invest in projects without a positive NPV. Managers do it because their intuition makes them aware that there are strategic components that the NPV does not capture. This is particularly the case for pharmacy and oil companies. But it is also the case for investing abroad.

 

There are also cases in which ROV does not promote more investment than the Discounted Cash Flow methods (e.g. NPV). In the Simple Investment Example we show how it may be better not to invest this year but rather wait for further information. In the case of investing abroad we also show that a positive NPV does not necessarily mean that the firm should invest in full capacity. It may be better to make a smaller investment, test the market, and then increase capacity only if profitability is as expected. The bottom point is that ROV does not promote more risk taking. It rather promotes different – and better – decisions. Sometimes it promotes investment; sometimes it does not. At Watson & Noble, we customize models to answer our clients’ problems to help them make more informed decisions.

 

There is one last reason why ROV have not been receiving a widespread attention: managers usually believe that DCF methods (e.g. NPV and Internal Rate of Return) are proven methods. DCF methods are quite powerful and intuitive. But naturally they have flaws. ROV extends the DCF methods to overcome these problems, bringing the intuition of managers into a unified model that promotes better decision making and Business Valuation.

 

 

Bibliography

Copeland, Tom and Peter Tufano 2004 "A Real-World Way to Manage Real Options" Harvard Business Review

Block, Stanley 2007 Are "Real Options” Actually Used in the Real World?" The Engineering Economist