Real options analysis and investment appraisal: the opportunities and challenges

Real Options Analysis allows us to recognise in a systematic manner the impact of future expansion and contraction decisions on value today, and hence on whether an initial investment is worthwhile

by Bruce D. Grundy

Listen to lecture - August 2008 (MP3 11.6MB)

Distinguishing between financial and real options

The option to pay a fixed amount in return for a share during a specified period – a call option – and the option to receive a fixed amount in return for a share during a specified period – a put option – are familiar examples of financial options, where the fixed amount is referred to as the option’s exercise price. Financial options are options to exchange a financial asset such as a share, a bond or a futures contract for cash. Less familiar, but no less important, are real options, which are options to exchange a real asset for some other asset. For example, undertaking an R&D program can give a drug company a real expansion option to acquire the revenues from any new product by paying the costs of producing and marketing the drug. The further option to discontinue the product later, should an even better mouse-trap be invented, is a real abandonment option to give up the low net cash flows from a failing product and to receive instead the scrap value of the machinery previously used to produce the product.

While financial options only truly blossomed in 1973 with the advent of the Chicago Board Options Exchange – initially situated in the smokers’ lounge of the Chicago Board of Trade – and the publication of the Black-Scholes Option Pricing Model, real options to alter the operations of an enterprise have always been with us. The mathematician and philosopher Thales (circa 635BC-543BC) made his fortune by correctly predicting a bumper olive harvest and buying options giving him the right to rent olive presses at the time of the next harvest in return for a pre-agreed fixed payment. When his forecast of high demand for olive presses proved to be correct, Thales was able to rent presses at well below what turned out to be a very high market rate that season.

Valuing options

Valuation techniques suitable for financial options such as the Black-Scholes model are often inapplicable when one wishes to value real options. The fundamental determinants of the value of financial options are usually clear and easy to measure. The exercise price and option maturity – usually a few months hence – are contractually defined, the market price of the underlying share or bond or futures contract is observable, and the volatility of the underlying price over the next few months can generally be accurately estimated. On the other hand, the opportunities inherent in real options to expand or contract a business are extremely complex. Further, the market can be relatively uninformed about the current value of the business that might in the future be expanded or contracted.

The estimation of the volatility of the future value of the business can be more an art than a science. Yet, valuing and operating the business today requires an understanding of how to optimally value and manage the inherent options to grow and shrink the business in the future.

The CEO of Berkshire Hathaway has expressed his view on the difficulty of valuing future growth options by musing: ‘On the final exam [for a business valuation course], I’d probably take an Internet company and [ask], How much is it worth? And anybody that gave me an answer I’d flunk…’ Most finance academics warm to these words, and not just because of Warren Buffet’s tacit approval of such a speedy method of grading exam scripts. Much of the difficulty lies in the looseness of language when discussing real options. The common practice of confusing choices and valuable options is at the root of the problem. Simply having a choice about how to manage a business does not imply that the choice, or the business itself, has any value.

When are property rights valuable?

Property rights that allow you to choose to give up one asset in exchange for another at off-market rates are valuable. Acquiring (or selling) an asset at off-market rates means acquiring (or selling) it for less (or more) than its market value. An option has value only to the extent the option-holder has an ability to do something others cannot – namely, an ability to exchange assets at off-market rates. A call option on BHP Billiton gives its holder an option to acquire a share in BHP at a fixed price, which is valuable precisely because everyone else who desires a BHP share must pay the market price – the option to buy a share at its market price is a valueless right. I might be happier to be able to include BHP in my portfolio, but having that right along with everyone else does not make me a wealthier man. The source of market value in any option, whether the option is real or financial, must be traceable to some property right that the owner of the option has.

An analogy may help. I have the option of remembering my beautiful wife’s birthday. And having optimally exercised that option I dutifully place $50 in my wallet and consider the option of buying flowers or chocolates. Again I know that life will be even more pleasant if I make the right operating decision and stop at the florist. Surely I am adding value. I then consider roses or tulips. Perhaps a difficult problem for some, but in my case I know that the optimal exercise strategy is to select tulips. I am feeling wealthier still. The choice between purple and red tulips is resolved appropriately and having made this series of important strategic choices the purple tulips are to be gift-wrapped. Now I feel like a king and with my Midas touch open my wallet and find but a single $50 note. Optimally exercising all my options has not added any value. My ability to exchange $50 worth of chocolates for $50 worth of purple tulips is not a valuable property right. Similarly, a company may face boundless choices and yet still be valueless.

Exercising a financial option

Even where the property right is clear, the optimal exercise policy of a real option may differ from that for a financial option. Consider a call option giving the right to acquire 1,000 ounces of gold at a fixed price of $500 per ounce at any time over the coming year. Call options on gold are financial options traded on the Commodity Exchange in New York. Suppose spot gold is trading for $900, the interest rate is seven per cent per annum and the one-year gold futures price is $963. The option must be worth at least $400 since the option-holder could immediately pay $500 cash to acquire $900 worth of gold.

The spot-futures differential in our example is such that gold is being priced as a store of value. The spot price is simply the present value of the futures price: i.e. $900 = $963/1.07. Suppose you were considering exercising your call today and netting the $400. You would be better off by not exercising today and instead:

Committing to exercise at the end of the year;
Selling forward the gold you will receive when you do exercise at year-end thereby locking in the receipt of $963; and
Borrowing $900 today against your future receipt of the forward price.

This alternative strategy dominates because instead of paying $500 today when you exercise immediately, you can earn one year’s interest on $500 by delaying any exercise on your call until year-end. And you would be better off still not committing to exercise your call at year-end, instead delaying till year-end and then exercising your call only if the gold price is above $500 at year-end. This is an illustration of the familiar injunction: never exercise a call option on a non-dividend-paying asset early. Since gold is typically priced as a store of value there is no convenience yield built into its price.

Exercising a real option

Now consider an apparently analogous real option. Suppose you manage a one-year lease on a site that you know contains 1,000 ounces of gold. For simplicity assume that at any time during the life of the lease the gold can be extracted instantaneously at a cost of $500 per ounce. The lease is in effect a call option on 1,000 ounces of gold with an exercise price of $500 per ounce and a one-year life. But what would happen if you manage the lease on behalf of a public company whose shareholders are concerned that this may be another Bre-X situation? (‘The Bre-X Gold Scandal: First there is a mountain of gold, then there is no mountain, then there is no gold mining company named Bre-X.’) If you simply announce the existence of the lease then, rather than netting $400 today, you would be delaying extraction till year-end. In the circumstances, the capital market may conclude that the shares are near valueless and your tenure as a manager would be brief. Therefore, you may find yourself forced to exercise the real option early to reassure investors that the underlying gold exists: information asymmetries between insiders and outsiders can affect the optimal exercise policy for real options when the firm’s goal is to maximise the current share price being set in a relatively uninformed market-place.

As a final example of the importance of understanding the property right underlying a valuable real option, suppose you are considering the purchase of acreage in a finger of the Yarra Valley at the edge of Melbourne with a view to planting grapes. The land is currently used for dairying. The investment in land and vines will amount to $10 million. In six years you will taste your first bottling, at which point you will discover whether you have produced a premium wine or yet another ‘blah’ wine. You must then decide whether to exercise your growth option and invest in the marketing and facilities necessary for a winery, or, alternatively, exercise your abandonment option and instead turn the property into a residential subdivision. Unless the wine is great it will be optimal to abandon grape-growing. You estimate the likelihood of producing a great wine. You also estimate the costs and revenues associated with producing wine and the costs and revenues associated with a residential development. You then estimate the expected payoff from your venture in seven years time, assuming that you exercise your growth and abandonment options optimally. Finally, you discount back at your estimate of the opportunity cost of capital and obtain an estimated present value of $25 million. On these calculations, the investment has a net present value of $15 million.

The skill source underlying this profitable venture

It is necessary to identify the source of the skill that enables an investment of $10 million to create a business that you value at $25 million. If you cannot identify your relative skill as either a vintner or a land developer, you should conclude that the present value is at best $10 million. Absent a comparative advantage, you can expect to lose rather than make money. But suppose you do have a rare skill. You have observed something unknown to others, namely, that the clay soil in just this finger of the valley is surprisingly similar to that of the Coonawarra region. You may well have discovered cool-climate Coonawarra country. Having identified your property right you must then seek to enhance it. For example, you might buy options to acquire the surrounding dairy farms. You will buy the options in case, some years later, when you may be winning wine medals based on the ideal soil of this property, your neighbours then want a much higher price for their land.

And, if you lack the capital to buy both this property as well as options on the surrounding properties, you should hide the real source of the value of the venture – the quality of the soil – by instead lauding the skills of your winemaking.

However, what if the valuable property right is in fact the skill of your winemaker? And that what you in fact possess is the ability to identify a uniquely gifted member of the graduating class of Roseworthy College in South Australia whose skill is currently not appreciated by others. In the circumstances, the present value of the expected future cash flows associated with your venture may really be $25 million. But who will be entitled to those profits if the winemaker does prove to be so skilled and you have immediately promoted her to chief winemaker? Your star employee is likely to demand the rents to her rare skill and you as the winery owner may enjoy only one gloriously profitable initial year. Thereafter, she will enjoy all the rents and you may as well subdivide the property.

Having understood that your particular skill is the ability to recognise skill in people before others also recognise it, how can you profit from your skill? Perhaps you need to try to convince your winemaker – and any would-be buyers of her services – that her skills are worth nothing without the unique blend of the soil on the property. Further, in initial contract negotiations with her, you might offer deferred compensation that gives her a large claim on the future profits from the winery in the form of restricted stock that will only fully vest if she works with you for 10 years. That way, you may also enjoy a share of 10 years of profits.

Readers who mutter that only a finance professor could recommend ‘underpaying’ young talented employees should remember that if you do not conceal certain facts and/or contract in a way that locks her in, you will have spent $10 million proving to the world just how valuable she is. Once you then find that you cannot afford to retain her and you are forced to subdivide, you will simply have lost money in giving her career such a great start.

The real promise of real options analysis

What, then, is the real promise of real options analysis (ROA)? First, ROA allows us to recognise in a systematic manner the impact of future expansion and contraction decisions on value today, and hence on whether an initial investment is worthwhile. Second, option valuation formulae can sometimes be used in addition to, but not as a substitute for, a traditional discounted cash flow (DCF) approach. A correctly implemented DCF approach to the valuation of a business will recognise and value the expected future net cash flows by optimally exercising any expansion and contraction options inherent in the business. When the two valuation techniques appear to yield different answers, it will be because inconsistent assumptions have been made about the business when applying the two techniques. Identifying and eliminating such inconsistencies will improve the accuracy of your valuation. Finally, and most importantly, the property rights that make the real options valuable must be identified and protected. If you cannot identify the property right, then any purported positive net present value associated with an investment opportunity will be no more than a mathematical error on your part. However, if you can identify the property right, then you can be confident that yours is truly a real option.

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A condensed version of his Alumni Refresher Lecture delivered at the University of Melbourne on 13 August 2008.

Professor Bruce Grundy is in the Department of Finance at the University of Melbourne.

Volume 4 NOV 2008