UK Accounting Glossary
A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm’s factory is a real option. In contrast to financial options a real option is not tradeable – e.g. the factory owner cannot sell the right to extend his factory to another party, only he has the decision to make. The terminology “real option” is relatively new, whereas business operators have been making capital investment decisions for centuries. However, the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such the terminology “real option” is closely tied to these new methods.
Certain critical components of real options make them a powerful analytical tool. First, they recognize and value the flexibility that today’s capital investments provide. Second, they recognize the staged nature of many investments and account explicitly for the reality that certain investments will never be made if — based on additional information developed over time–they are deemed unattractive. In these instances, it makes sense simply to abandon them, rather than sink additional monies into a poor investment. By contrast, DCF (Discounted Cash Flow) evaluates a series of investments as if they will be made, regardless of whether they still make sense at a later date.
Additionally, with real option analysis, the uncertainty inherent in investment projects is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach). Cash flows can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate (using e.g. the cost of capital) or the cash flows (using certainty equivalents). These methods normally do not properly account for changes in risk over a project’s lifecycle and fail to appropriately adapt the risk adjustment. More importantly, the real options approach forces decision-makers to be more explicit about the assumptions underlying their projections.
Another critical difference between DCF and real options is the effect of uncertainty (or risk) on value. Uncertainty is typically considered bad for the valuation of traditional cash flows. By contrast, uncertainty increases the value of real options.
Real options are not universally recognized as a means of valuing capital investments. Yet, the now ubiquitous capital asset pricing model did not become a common pricing model overnight, either. Consider the following key points:
Initiatives with great uncertainty should be implemented in stages. Making a small investment upfront can give management the ability to resolve uncertainty through data gathering and learning. The larger investment can be made in a future environment with less uncertainty.
Real options recognize that abandonment is a viable alternative that must be contemplated from the outset. Furthermore, dropping a project does not necessarily mean that the team in charge of the particular initiative has failed.
Technology investments might often grant the possibility of pursuing an avenue in several months or a couple of years. But without the relatively small initial investment, an opportunity might be foreclosed forever. Although real options can be intuitively appealing, execution to arrive at a value is difficult. Determining the exact value of a real option is not necessarily critical. Instead, understanding the drivers of the valuation and the value relative to traditional methods is much more important.
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This glossary post was last updated: 20th February 2020.