Integrating Options and Discounted Cash Flow

Real options method is, Real Option

CFOs tell us that real options overestimate the value of uncertain projects, encouraging companies to overinvest in them. These concerns are legitimate, but we believe that abandoning real options as a valuation model is just as bad.

How can managers escape this dilemma?

This is the first of two articles which considers how real options can be incorporated into investment appraisal decisions. This article discusses real options and then considers the types of real options calculations which may be encountered in Advanced Financial Management, through three examples. The article then considers the limitations of the application of real options in practice and how some of these may be mitigated.

In exploring their reservations about real-option analysis as a valuation methodology, we have come to the conclusion that much of the problem lies in the unspoken assumption that the real-option and DCF valuation methods are mutually exclusive. We believe this assumption real options method is false. Far from being a replacement for discounted cash flow analysis, real options are an essential real options method is because they allow managers to capture the considerable value of being able to ruthlessly abandon floundering projects before making major investments.

There are. These are not, of course, the only difficulties managers encounter using real options, but they are perhaps the most fundamental sources of error, and the integrated approach we present here explicitly addresses them both.

Adjusting for Cost

Integrating Options and Discounted Cash Flow Traditional DCF analysis relies on the straightforward principle that an investment should be funded if the net present value NPV of its future cash flows is positive—in other words, if it will create more value than real options method is will cost.

This works well if we are projecting future cash flows from some historical context, and we are fairly certain of future trends, but not when our estimates of future cash flows are based on a myriad of assumptions about what the future may hold. In such cases, the odds of accurately forecasting cash flows are pretty slim. As a result, all the risks of uncertainty the possibility that actual cash flows may be much lower than forecast are captured in the valuation but none of its rewards the possibility that actual cash flows may be much higher than forecast.

This inherent bias can lead managers to reject highly promising, if uncertain, projects.

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The challenge, therefore, is to find a way to recapture some of the value lost through the conservative DCF valuation while still protecting against the considerable risks of pursuing highly uncertain projects.

This is where options come in. The possibility that the project may deliver on the high end of potential forecasts, so hard for DCF analysis to take into consideration, is the primary driver of option value.

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Options provide the right but not the obligation to invest in a project. Their value, therefore, is driven by the possibility of achieving a large upside gain combined with the fact that companies real options method is usually abandon their projects before their investment in them has cost too much, thus limiting the downside.

One caveat though. It can hardly be stressed enough that a real-options approach can only be used on projects structured somewhat like options—that is, on projects that can be abandoned before you must commit yourself to making major financial outlays if it becomes clear that things will not go well. It would not apply, for instance, to valuing an opportunity that requires you to sink huge sums into building a new factory before you have the first inkling whether the bet will pay off.

In the early stages of an innovative project, the value of the DCF component will be low because of the need to use a high discount rate to adjust for the uncertain nature of future cash flows. At the same time, the real-option value will most likely be high due to that same uncertainty. To the left of the diagram, uncertainty is high, so the project value, as measured by the vertical axis, is composed largely of option value, and DCF value is low—even, conceivably, negative.

Now, uncertainty should reduce over time if it does not, shut down the project! But growing certainty also decreases the option value component of the project.

The greater the uncertainty, the larger the option component and the smaller the discounted cash flow component. Then it will be in the deep-in-the-money zone. But between the flee zone and the deep-in-the-money zone is what we call the option zone, where the contribution of the option component adds meaningfully to TPV.

It is here that traditional DCF valuations usually clash with management intuition, and so it becomes important to compute both the DCF and the option value of a project. In this example, project A depicted by the solid vertical lines is squarely in the option zone. As project A progresses, uncertainty should be reduced, so the vertical line should move to the right, as escalating certainty increases the DCF component and decreases the option value component.

If the DCF valuation is high, the decision is easy—simply proceed, since success in the real options method is seems very certain, and it is likely to pay off handsomely. If the DCF valuation produces a strongly negative number and all the value comes from the option, then the project should probably be rejected, unless an investment structure can be created that would allow managers to learn a great deal about the project quickly and for very little cost.

This rule of thumb may cause companies occasionally to miss profitable investments, but in our experience most large firms have more projects than they can fund or real options method is. So even if the option value is high, why waste time on a project that carries a large negative DCF value?

It is simply too risky, so move on to something better. The majority of growth projects, we have found, lie somewhere in the middle. It is here that our framework is particularly useful because the option value can provide logic to support or refute that intuition. Adjusting for Cost That said, there remain two serious problems with option valuations.

THE REAL OPTIONS APPROACH TO VALUATION: CHALLENGES AND OPPORTUNITIES

First, it is hard to find good proxies for the input variables the model requires. Financial options use a volatility measure derived from the easily observed historical prices of the underlying assets.

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But there are almost by definition no historical numbers that managers can use when trying to derive the option value of an innovative project—even to real options method is the net present value of the underlying asset, let alone its volatility.

Not the least of them is trying to establish a figure for volatility, for which there are often no historical numbers. Then for each factor, we specify the range of possible values. These ranges whose widths reflect their associated uncertainties are put into a Monte Carlo simulation, from which we extract the means and standard deviations of total profits, total revenues, and total costs. The standard deviations of profits, revenues, and costs are used in the calculation of adjusted volatility described in this article, and this adjusted volatility is then used in the option valuation.

The mean of the project value, discounted back at a risk-adjusted rate, becomes the proxy for the current price of the underlying asset.

We would emphasize, however, that if the original projections are flawed which is very possible with a highly uncertain growth project or if the discount rate is wrong even more likelythe volatility and exercise price estimates will also be wrong. Realistically, in fact, with highly uncertain projects, any method, no matter how sophisticated, will be wrong.

Hence our contention that time spent worrying about the exact option value of a project is time wasted. What valuation can investment in options should do is establish relative values within a portfolio of opportunities, providing a means of ranking the contenders, so that managers can select only the most promising.

That way, managers will, in the long run, select better projects than their more timid competitors while keeping risk under earn money for entry and thus outperform their rivals in both the product and the capital markets. Another source of error involves the time period used in the calculation, and this is even more difficult to resolve. With a financial option, the more time we have before we commit to buying the underlying asset, the more valuable the option.

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This makes sense because the stock has more time to increase in value, and if it does not, we need not exercise, so financial options with longer expiration periods have more value than those with shorter lives all other things being equal. Bitcoin difficulty chart logic does not extend to the real world, however.

Delaying a product launch will not necessarily add value to a project because you end up paying a discount penalty and could even end up missing the market. The relationship between time and value is much less consistent with real options than it is with financial options.

The best way to handle the problem is to formally recognize this competitive reality. We assume that the project is launched immediately because there is no bonus for delay. If the project is delayed, we actually discount the total project calculation of CM options for the period it is delayed.

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Second, even if managers succeed in finding good proxies for the option-model input variables, they remain vulnerable to a major conceptual error. In the current approaches to option valuation, the more variable the profits, the higher the project valuation.

Real Option Definition

The variability of profits, in turn, is derived from estimates of how uncertain both revenues and costs are likely to be. This seems reasonable but leads to an impractical result: Mindless option analysis will value a project with relatively predictable revenues but unpredictable costs more highly than a project with the same predictable revenues but with predictable costs. We think this is wrong. When the uncertainty about potential costs is higher than the uncertainty about potential revenues, cost volatility should decrease, not increase, the value of a project.

Unlike revenues, where volatility how to open make big money imply as much upside potential as downside, when it comes to costs, the potential for downside is generally much greater. That is, the margin by which costs overrun their estimates is almost always greater than the margin by which they underrun them.

We do not routinely see cost savings on anything like this same scale. The experience of a large industrial company we worked with that was venturing into biotech aptly illustrates how easily the costs of a growth project can spiral out of control when a company is operating in areas far from its expertise and experience.

At the time we became involved, project managers had already spent money on toxicity testing and had made other large safety-related expenditures, followed by sophisticated consumer testing, all of which best binary options chart that the compound held considerable potential to command high prices.

But the firm had not yet tried to ramp up manufacturing to produce the real options method is in commercial quantities. It turned out, though, that the manufacturing process was hugely more difficult than anticipated. The cost to produce the compound would real options method is in the order of hundreds of dollars per unit, which put it outside the range of commercial viability. Had company managers taken cost volatility into account effectively, they would have managed the project differently.

First, they would have realized sooner that the manufacturing process represented the greatest part of the uncertainty surrounding the project. Second, taking into account cost volatility would also have produced a much smaller total project value, which would have led them to curtail investment in the project at an earlier stage, saving them millions of dollars.

Since costs are volatile in a different way than revenues are, the formula for determining option value needs to be adjusted when cost volatility is greater than revenue volatility. In practice, however, there is no need to compute the impact of cost volatility separately from the impact of revenue volatility. There is real options method is simpler approach that is good enough for inferring the AOV of a project, when necessary, and that has the advantage of being simple and quick.

So rather than being concerned with whether a particular valuation is precise, managers should look at it as a yardstick that allows them to choose the best among competing projects. As long as they feel sure that all the projects applying for funds are being valued in the same way, they can be reasonably confident that they will, on average, select and assign resources to the best ones. Managers need only know whether a project is preferable to others competing for how i made my first money online funds and talent.

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So, keeping it simple, to give costs a truer real options method is in an option valuation, when cost volatility is greater than revenue volatility, we adjust the volatility of the project as a whole the volatility number we normally input into an option calculation to reflect the negative nature of cost volatility.

In other words, if we are more certain about the projected revenues than we are about the projected costs, then the ratio of revenue volatility to cost volatility will be less than one, which will reduce the overall volatility, and that, in turn, will reduce the option value of the project. This adjustment has the effect of discounting the value of the option due to the higher cost volatility. If revenue volatility is higher than cost volatility, then the project volatility variable in the real-option calculation need not be adjusted.

Adding the Rewards of Failure Failing to adjust option value to reflect cost risks is not the only source of error. Real options method is searching for ways to reduce cost volatility, managers often find they can recoup some of the investments they have made, in the event of failure.

These opportunities for creating extra value when halting a project can be seen as the equivalent of the put options familiar to financial investors, which serve as a hedge against drops in the price of the underlying asset. In some cases, early investments that have to be abandoned can be valuable to another business unit within the same company. Take the example of a large industrial company that had developed a plant-based vitamin precursor.

Another division of the company, however, picked up the compound and used it in a joint venture that was developing new food additives for the Asian aquaculture industry, where the compound was shown to accelerate the growth rate of farm-raised shrimp.

Making Real Options Really Work

In other situations, the early investments real options method is have created an asset that can be traded for cash or equity in another company.

GlaxoSmithKline, for example, developed an experimental antibiotic that showed promise in treating drug-resistant staphylococcal infections but was thought unlikely to become the sort of blockbuster drug the company needed to support its growth rate. Rather than consign the intellectual property to its library of interesting compounds, the firm generated abandonment value by trading the patents, technology, and marketing rights to develop this antibiotic for equity in Affinium, a privately held biotech company.

If the opportunity to create value on exit exists or can be made to exist, then managers should include that factor in their project valuations.

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This involves another option calculation. Because the exit option is usually a relatively simple real option a put optionmanagers can fairly easily apply financial tools like the Black-Scholes-Merton formula. The estimated value of the asset created by the aborted investment is the exercise price. The historical range of prices paid for comparable assets determines the volatility.

The date on which the real options method is has to decide whether or not to continue investing in the project is the time to expiration. The project has three phases, and the assets could be sold if the venture is dissolved at the end of phase one, in about two years.

The Option Zone in Real Life Our integrated approach to investment is not just an exercise in theory. John Hillenbrand and Mary Kay James of DuPont Ventures, working with consultant Hal Bennett and John Ranieri, vice president of DuPont Bio-Based Materials, have for some time been using an expanded concept of total project value that is very similar to the approach set out in this article. DuPont Ventures looks for externally owned new technologies that could be commercialized by a DuPont business unit.

When Ventures finds an interesting technology within an early-stage company seeking financing, the unit will buy into the current round at the same valuation as other investors, on one condition. If no license agreement is completed, Ventures still retains its equity interest in the target company, which may or may not have liquidity in the future.

In making the decision to invest, Ventures uses all the elements of our valuation approach: discounted cash flow, adjusted option value, and abandonment value.

The next step in the analysis, therefore, is to work with interested business units within DuPont that might possibly commercialize the technology to generate more complete projections and calculate the option value of the investment.

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In making these projections, Ventures looks closely at the range of costs that DuPont will incur if it were to commercialize the technology, as well as the uncertainty surrounding the yet-to-be negotiated license terms with the target company. That leads to a cost volatility estimate. The result of this exercise is equivalent to the AOV term in our real options method is. Finally, Ventures also takes into account the fact that it will retain an equity interest in the target firm, which could potentially be sold whether or not a DuPont business unit invests in the technology.

The approach has worked well for Ventures, which has developed a robust portfolio of promising opportunities that it would otherwise have missed. The integrated approach we have presented attends to those concerns and will enable senior managers to make more aggressive investments while meeting their fiduciary responsibilities.

We invite managers to test it out on a few pilot projects—ones that their gut feelings tell them deserve funding despite what the DCF numbers suggest or ones with high option values about which they nevertheless have reservations.

And no valuation method will save a company that does not actually pull out quickly, if the project fails to deliver on its initial promise, and redeploy talent and funding elsewhere. If this fundamental option discipline is not baked into every option real options method is, you are not investing, you are gambling. See Robert K. Dixit and Robert S.