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

EMPIRICAL EVIDENCE ON THE USE AND ACCURACY OF REAL OPTIONS VALUATION

The literature on real options is replete with theory. Many writers have developed interesting, but usually oversimplified, examples of real options—some taken from their consulting experience. We will take a look at what the empirical research on real options says. In other words, does theory match up with practice?

Direct and Indirect Tests

The studies discussed in this section are either direct or indirect tests of whether the predictions of real options models hold up in practice.

Paddock, Siegel, and Smith

James Paddock, Daniel Siegel, and James Smith (1988) develop a real options model for valuing offshore oil and gas leases in a 1980 federal sale of 21 tracts in the western and central portions of the Gulf of Mexico. Companies buy the rights to drill in certain tracts. Drilling may reveal that oil or gas is present, in which case the company can choose to develop the tract into a well. The authors obtain input data and compare option values with prices at which the tracts were auctioned by the United States Geological Service (USGS). A comparison of prices obtained from real options valuation models with bids placed by companies, as well as estimates obtained from the USGS, provides encouraging but not corroborative results. In other words, real options models were not able to explain the bids as well as one might have hoped. Note, however, that this study was published in 1988, a time when real options ...