REAL OPTION VALUATION
Real option valuation techniques are often viewed as enhancements to more traditional net present value (NPV) approaches. 1 7 One of the weaknesses of NPV approaches, similar to any forecasting method, is that it requires relatively precise knowledge about the timing and amount of cash inflows and outflows associated with an investment, and appropriate discount rates. Option values, on the other hand, impute uncertainty and the value of choice. Furthermore, and critically, the discounted cash flow approach generally assumes that the manager does not change investment decisions and/or react to environmental changes over. The cash flows (both positive and negative) that were forecasted before project pursuit generally remain unaltered even as new information is uncovered.18 Similarly, the rate at which cash flows are discounted should adequately reflect the risk of the investment's cash flows. If the risk of those cash flows varies throughout the project (as they often do), the discount rate should reflect these changes. NPV approaches fail in this regard.19
I n addition, the discounted cash flow models do not adequately address the intrinsic value of investment opportunity. The intrinsic value, described as the difference between the actual value of an investment and the market price of the investment, may result from embedded options (which we will discuss in more detail later). As mentioned earlier, the traditional valuation methods value cash flows, and not the options that could enable management to take corrective actions to improve the cash flows.
Based on these weaknesses of the traditional models to address the value of real options, a new set of valuation methods specific to real options has emerged. Among those the Black-Scholes model20 is the most prominent model. On a very basic level, this model essentially applies the law of one price, which states that in efficient markets, all identical goods must have the same value (or price) after, if applicable, exchange rate are taken into consideration. The reason that markets are assumed to be efficient is due to the concept of arbitrage; if prices for the same good or service would be different in different markets, then an arbitrageur would purchase the asset in the cheaper market just to sell it in the market in which the price is higher.
The difficulty is that most real options are not traded on a market since they may be uniquely possessed by the firm (e.g., a firm's ability to alter its own product mix, or to use established logistics and distribution systems to enter a new market). This creates the problem of efficient valuation. To circumvent this problem, one could establish a dynamic tracking portfolio that consists of investment opportunities with the same, or very similar, payoffs than the firm's option but comprising traded assets.
The law of one price then suggests that the option, though not traded, ought to be valued the same as the portfolio of traded investment opportunities with the same payoff. Since those "other" investment opportunities are traded on efficient markets, their price ought to accurately reflect their actual, true value. As a result, the price of a firm's option is derived off a comparable investment.
ITERATIVE INVESTMENT AND COMMITMENT
Whereas many investment decisions are often framed as all-or-nothing decisions (e.g., sell/keep a division; make/buy inputs), option-based strategies emphasize the value of iterative investing (at least under specific conditions) rather than committing unconditionally at the outset to a project.21 Assuming that a project can be iteratively planned so that decisions to continue/terminate can be made after each stage, incremental investing allows the firm to avoid committing to the entire cost of the project upfront (and thus subjecting a firm to significant exogenous uncertainty), and permits gathering of information over time to assess whether the next investment (and the entire project) remains feasible (i.e., allows the reduction of endogenous uncertainty).
To demonstrate, consider the example of pharmaceutical development. Drug development faces considerable uncertainty in terms of type and magnitude. Endogenous uncertainty results from low probabilities that the technology will be safe and effective in humans. Exogenous uncertainty stems from, among other things, societal acceptability of a treatment even if it is demonstrated to be therapeutically effective (witness, for example, the weak marketing efforts for many approved family planning devices). In light of these uncertainties, managers must carefully manager their firms' option "chains." Instead of committing up front to a single project (whose success may cost hundreds of millions of dollars), options strategies often dictate small initial investments in a variety of projects to assess feasibility before final commitment. If some projects fail, these can be abandoned (or used as platforms to develop other therapies). In contrast, managers can provide further incremental funding for the pursuit of projects that demonstrate some efficacy in the current stage. Mismanagement of option strategizing (e.g., overcommitting to a project in times of uncertainty) can have drastic consequences. Committing to the of building a plant to manufacture a drug for clinical trials before assessing the efficacy of the drug in animal models, or before assessing the degree to which the drug will be socially accepted subjects the company to considerable risk of investment loss. Holding options on land to build a plant, and simultaneously conducting background research on contract manufacturers are ways of avoiding such commitment under uncertainty.