Valuing Real Options: Insight from Competitive Strategy
journal contributionposted on 01.12.2005, 00:00 authored by Andrew G. Sutherland, Jeffrey R. Williams
Growth opportunities and future strategies can comprise a significant proportion of a firm’s valuation. At the end of 2006, the median company in the S&P 500 and Russell 3000 had 25% and 40% of their valuation, respectively, attributed to Future Growth Value (FGV®), the capitalized value of future profit growth1. 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 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 continent decisions about real assets, classic examples of “real options,” and those of financial securities whose value is derived from the price of something else. The Black-Scholes model and Binomial Lattices have emerged as the most frequently prescribed and used tools for evaluating real options within both capital budgeting and enterprise valuation contexts. With the classic real option decision growing increasingly complex, and managers becoming more sophisticated, a frank assessment of modern valuation tools is timely.