Real Option Valuation: An Introduction
The valuation of real options is a methodology applicable to the process of evaluating M&A opportunities. Topic 45 explores the definition of real options, the applications of real option analysis to M&As, the interpretation of the real option result and what it really means, and the methodology of how to perform real option valuation in an M&A setting.
DEFINITION AND DEEPER VALUE OF REAL OPTIONS
- “Real options” are potential investments in income-producing hard assets—hence “real”—at some time in the future (as opposed to an option to invest in a financial instrument at some future date).
- A real option is the right to make, sell, or delay an investment at some future time.1
- The value of a real option is the value today of the flexibility of having the right to make (or sell or delay) the future investment, just before the real investment opportunity is no longer available or determined to be viable.
- Real options have value under conditions where an investment, if made, is irreversible (e.g., pouring concrete and erecting steel for a new plant, entering into a long-term contract, acquiring technology). They are made in a world where potential returns and their timing are uncertain and very volatile.
- The greater the volatility (standard deviation) of the potential returns from the investment (make a lot or lose a lot) net of the cash investment required (the “exercise price”), the greater is the “option value”: the value of the flexibility, ...