What are real options?

Companies have invested in real assets for centuries, usually with the help of their astute decision makers. With modern theories of asset pricing and investment appearing in the early and mid– twentieth century, we had consistent methods of analysis at hand that could combine the available information and take transparent steps towards clarity in investment decision making. The new methods were later strengthened with the advent of digital computing and had the potential to turn investment decision making upside down, but, this really didn’t happen in reality. The question is, where did we go wrong?

The answer may not be straightforward. While uncertainty, inappropriate technology, environmental and regulatory issues, and increasing complexity of trades are to blame, perhaps also our valuation models are not duly sophisticated.

First and above all, the valuation models should reflect that investment projects are subject to uncertainties that resolve over time. If projects are flexible, the resolution of uncertainties over time provides opportunities to change course and generate value. For example, the amount of gold in a gold mine is uncertain but as extraction continues the extent of gold–bearing veins are better known. If the owner is studying an expansion project, the resolution of uncertainty will be of great help in making this decision.

Second, the valuation method should capture the relationship between real asset and market movements. The markets provide a medium for hedging risks and evaluating decisions. In our gold mine example, knowing about the expected trend in the price of gold, besides knowing about the extent of gold–veins, informs the decision about the expansion project.

Third, our models should be capable of handling complex cash flow structure. As an example, some cash flows are a function of multiple uncertainties, and the aggregate affect may not be straightforward. In our gold mine example, the cash flows may not be a simple function of gold price, but also related to production of an equally valuable by–product, the copper ore. The cash flows are then a complex function of gold and copper prices, perhaps also convoluted with a myriad of technical and regulatory constraints.

Then what is a consistent method of real asset valuation? Those interested can read a conference paper I co–authored a few years ago about “Real Options” in which we discuss in favour of simulation–assisted valuation methods.

Babak Jafarizadeh

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