Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference
Add the QFINANCE search widget to your website

Home > Business Strategy Best Practice > Real Options: Opportunity from Risk

Business Strategy Best Practice

Real Options: Opportunity from Risk

by David Shimko

Executive Summary

Real options arise from the ability of economic agents to adjust their behavior to maximize the values of their assets or contracts.

  • Common examples are the right to make, expand, contract, defer, or cancel an investment or contract.

  • Value real options by considering the value of the asset or contract with and without the ability to adjust.

  • In some cases, the Black–Scholes model can be used to approximate the value of real options directly.

  • Real options generally increase in value as uncertainty about the future increases.

  • Real options can be proprietary or shared, simple or compound, restructurable or not.

  • Real options have real value; many corporate valuations cannot be explained except for the presence of real options.

What Is a Real Option?

The origin of the term “real option” derives from financial options. For example, the right to buy a house for a fixed period of time at a fixed price is a call option,1 except that the underlying asset is a real asset, not a financial asset. Business people and economists discovered that many business processes involve options, and that financial mathematics can be brought to bear to value those options. Some popular examples include:

  • the right to make an investment, such as the option to build a plastics plant in China;

  • the right to expand or contract an investment based on changes in market conditions, such as a plant design that accommodates changes in production rates at very low cost;

  • the right to defer an investment, such as the right to wait for better market conditions to develop a property;

  • the right to accelerate an investment;

  • the right to cancel a contract;

  • the right to produce or not to produce a product, such as the right of a petroleum refinery or electricity power plant to produce or not produce fuel or power;

  • the right to choose how to undertake an investment, such as a gold producer’s right to choose the mining strategy that maximizes its value.

“Option” and “optimize” share the same root, the word “opt”—meaning, of course, “to choose.” Therefore, the value of a real option can be thought of as the value of any right to choose, when compared with following a strategy where no such right is conferred. This suggests the mathematical relation:

Value of real option = Value of strategy with decision rights – Value of strategy without decision rights

In some cases, the option value may be computed directly, as shown in Example 1.

Example 1

A company has a one-year option to acquire an oil-producing property for $100 million. The present value of the drilling profits is currently estimated to be $100 million, and the oil reserves are currently being depleted at the rate of 2% per year. The present value assessment varies according to the price of oil, with a percentage volatility (standard deviation) of 15% per year. If the interest rate is 4%, what is the value of the option?

To value the option, it is helpful to see how the real option resembles a standard financial call option. The owner of an equity call option has the right to buy a stock at a predetermined price (the strike price) for a predetermined period of time. The stock pays dividends which the option holder will not receive if the option is unexercised. Stock volatility makes the option valuable—the more volatile the stock, the greater the value of deciding to buy later at a fixed price. In the case of the oil option, the “stock value” is the present value of the profits, the “volatility” is the percentage variation in the present value, the “strike price” is the acquisition price of the property, and the “dividend” is the depletion of the oil reserve.

As a first approximation, an analyst might use the Black–Scholes formula of stock option pricing to value the real option. Using any online calculator, and the inputs below, the resulting call option value is $6.82 million.

Stock priceUS$100
Dividend2%
Exercise priceUS$100
Volatility15%
Interest rate4%
Time1 year
Call option value = US$6.82

Some real options fit the Black–Scholes framework nicely, but most real options have degrees of complexity that are not captured by the option pricing model.

Example 2

A developer owns a piece of land that is currently used as a parking lot. The present value of the parking lot revenues is $5 million. He can convert the land into an apartment building and net an additional $5.5 million in present value. Or he can convert the parking lot into an office building and net an additional $6 million in present value. What is the value of the property in this case?

  1. US$5 million, since it currently being used as a parking lot.

  2. US$11 million, since the office project is more profitable than the apartment project.

  3. The value of the highest current net present value (NPV) usage of the land.

  4. None of the above.

The answer is clearly not 1; a parking lot is worth more than the present value of its current income since it has demonstrated valuable alternative uses. Answer 2 is tempting, but it is wrong if there are any other projects more valuable. Answer 3 may be correct, but also could be incorrect because of the use of the word “current.” It may have a more valuable use in the future and, under some conditions, it would be worthwhile to wait to develop the land until that possibility materializes.

The correct answer is generally 4, since the value of the land is equal to or higher than its current value in the highest use. The reason for this is that conditions change over time. If the property owner waits a year, they may find that residential real estate grows faster than commercial, or vice versa. At some point, however, it is optimal to make the irreversible decision as to how to convert the property. In those cases, the value of waiting is zero.

Because the property owner has the right to wait to invest, this confers additional value to investment until the moment when it is no longer optimal to wait, and the option is exercised.

Back to Table of contents

Further reading

Books:

  • Copeland, Tom, and Vladimir Antikarov. Real Options, Revised Edition: A Practitioner’s Guide. New York: W. W. Norton, 2001.
  • Kodukula, Prasad, and Chandra Papudesu. Project Valuation Using Real Options: A Practitioner’s Guide. Fort Lauderdale, FL: J. Ross Publishing, 2006.
  • Mun, Jonathan. Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions. 2nd ed. New York: Wiley, 2005.
  • Schwartz, Eduardo S., and Lenos Trigeorgis. Real Options and Investment Under Uncertainty: Classical Readings and Recent Contributions. Cambridge, MA: MIT Press, 2001.
  • Trigeorgis, Lenos. Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge, MA: MIT Press, 1996.

Website:

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share