Valuing Real Options: Insights from Competitive Strategy

THE VALUATION HANDBOOK: VALUATION TECHNIQUES FROM TODAY'S TOP PRACTITIONERS, Forthcoming

Posted: 29 Sep 2008 Last revised: 17 Sep 2013

See all articles by Andrew Sutherland

Andrew Sutherland

Massachusetts Institute of Technology

Jeffrey R. Williams

Tepper School of Business, Carnegie Mellon University

Date Written: September 15, 2008

Abstract

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, the capitalized value of future profit growth. 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 contingent 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.

Keywords: Real Options, Valuation, Option Pricing, Corporate Finance, Investment Analysis, Capital Budgeting, Competitive Strategy, Competitive Dynamics, Business Strategy, Economic Value Added, Future Growth Value

Suggested Citation

Sutherland, Andrew and Williams, Jeffrey R., Valuing Real Options: Insights from Competitive Strategy (September 15, 2008). THE VALUATION HANDBOOK: VALUATION TECHNIQUES FROM TODAY'S TOP PRACTITIONERS, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1268531

Andrew Sutherland (Contact Author)

Massachusetts Institute of Technology ( email )

100 Main Street
Cambridge, MA 02142
United States

HOME PAGE: http://https://mitsloan.mit.edu/faculty/directory/andrew-gordon-sutherland

Jeffrey R. Williams

Tepper School of Business, Carnegie Mellon University ( email )

Carnegie Mellon University
5000 Forbes Ave
Pittsburgh, PA 15213-3890
United States

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