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The Valuation Handbook: Valuation Techniques from Today's Top Practitioners by Rawley Thomas, Benton E. Gup

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CHAPTER 13
Valuing Real Options
Insights from Competitive Strategy
 
Andrew G. Sutherland
Vice President, Stern Stewart & Co.
 
Jeffrey R. Williams
Professor of Business Strategy, Tepper School of Business at Carnegie Mellon
 
 
Growth opportunities and future strategies can comprise a significant pro portion of a firm’s valuation. At the end of 2006, the median companies in the S&P 500 and the Russell 3000 had 25 percent and 40 percent of their valuations, respectively, attributed to Future Growth Value (FGV®), the capitalized value of future profit growth.1 Acquisition premiums can also be interpreted as estimates of value creation attributed to new tactics and operational improvements under a new regime. Unfortunately, managers often find static net present value (NPV) tools and trading multiples to be too rigid to evaluate the contingent nature of strategic decisions and the cash flow recovery profiles associated with possible outcomes. For example, Microsoft was willing to develop its Xbox platform at a loss because it expected subsequent game and peripheral offerings linked to it to generate significant profits. Similarly, commodities producers frequently choose to delay extraction until output prices swing in their favor. Academics and practitioners have recognized the similarities of payoff functions between such contingent decisions about real assets, classic examples of so-called real options, and those of financial securities whose values are derived from the price of something ...

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