Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

A FRAMEWORK FOR THE VALUATION OF REAL OPTIONS

Determining the value of a real option is not a simple process. Fortunately, a well-developed body of financial theory provides a rich framework from which real options values can be estimated. The theory of option pricing was developed primarily to value financial options, which are options on stocks and stock indexes, bonds, and currencies. To say that it has been successful is perhaps an understatement; the foundations of a multitrillion-dollar global industry are based on the theory of financial option pricing. Every day, large commercial and investment banking firms make markets in financial options for a clientele of corporations, pension funds, and governments.

Financial option-pricing theory does not solve all of the problems of valuing real options, but it does provide a basis for valuing instruments that have similar cash flows and payouts. Note, however, that our use of the term “theory” does not imply an abstraction from reality. Although we shall indeed start with a simple framework, one seemingly far removed from reality, we do so for the purpose of gaining an understanding of the process of option valuation, which is critical to comprehending real options.

Valuation of Financial Options

We begin our investigation of the valuation of financial options by forgetting the world of corporate real assets and focusing on an option on a simple security—an actively traded common stock. Suppose that the stock is priced today at ...