Featured Article from CIRE Magazine – “Gaining Options: Evaluate if real options will add real value to an asset” with Sterling Valuation Outside Expert, Richard J. Buttimer, Jr., Ph.D.
Evaluate if real options will add real value to an asset
Investors in large, non-financial assets, such as land or factories, frequently value them through a “real options” framework. But what are real options, how do they differ from financial options, and how can their use add value to an asset or company?
Most investors are familiar with financial options, such as call options on stocks, which give the holder the right, but not the obligation, to buy the stock in the future for a price specified in the option contract. Call options on stocks have been traded widely on exchanges since the early 1970s, and they are used routinely both to hedge investment risk and to speculate on future price appreciation of the stock. The famous Black-Scholes model provides a way to explicitly price these options.
Real options, in contrast, are not traded, but are provisions on how investors may respond as uncertainty is resolved. With real options, an investor has flexibility in responding to future uncertainty, and this flexibility (the option) itself has value.
Applying Real Options
Consider an investor in a factory that currently runs one shift per day, which meets current demand for a product. The investor believes that demand may increase in a year, but recognizes that it may not. If demand does increase, the investor could begin a second shift at the factory, but if demand stays flat, the operation would remain at one shift. This option to begin a second shift in the future, if conditions warrant it, is called a real option.
Now consider if the investor wants to value the factory today. In its traditional form, the most widely used investment valuation methodology – discounted cash flow analysis – doesn’t consider the uncertainty in what will happen a year from now. The standard approach considers the most likely outcome only, and assumes that will happen. It fails to consider the value in the option to decide later whether to add a new shift. The traditional DCF approach would undervalue the factory.
Both academics and practitioners proposed methodologies that incorporate real options into investment valuations, as described in the textbook Investment Under Uncertainty by Avinash K. Dixit and Robert S. Pindyck (Princeton University Press, 1994). Although many techniques and methodologies are available, they all share a common trait: They explicitly build into the investment valuation model uncertainty about the future and value the flexibility the investor has as that uncertainty resolves.
A first step in determining the value of real options is simply knowing what they are. Understanding the nature of real options helps in understanding whether they are likely to have value, and whether traditional DCF is likely to underprice that value.
With real options, an investor has flexibility in responding to future uncertainty, and this flexibility (the option) itself has value.
Real Options Illustrated
Consider two investments – one in a piece of undeveloped land and another in an existing factory.
In the case of raw land, the investor has many real options: the timing of when the land will be developed, based on how demand evolves; developing the land for residential or commercial use; developing the land all at once or in phases; and whether to develop the land or abandon the project. At the time the land was purchased, the investor was buying a bundle of real options to exercise at some point.
Similarly, the investor in a factory can decide when to increase or decrease production; expand or reduce the capacity of the factory; shut the factory down, and the conditions under which it would be restarted; and retool or even abandon the factory should demand for its product not meet expectations. The most common real option and one of the most valuable is the option-to-delay. This option affords the investor flexibility to delay making a decision up to the point when an irreversible decision is made. Option-to-delay has critical value because it gives time to collect more information about the decision, and it gives any uncertainty surrounding the decision time to resolve. In short, this and all of the other real options available to investors have real value, and should be reflected in the valuation of the entire investment.