my first million: Are Real Options the best approach for valuation of a new high-tech venture?

For a long time, business schools have been teaching their students how to value different investment choices by using the net present value method (NPV) or the capital asset pricing model (CAPM). However, Gilbert said in his article “An Introduction to Real Options” that using either of these valuation methods is inappropriate for investment options with expected future cash flows characterized by significant uncertainties and wherein “management have the flexibility to respond to these uncertainties” (2004, p. x). He suggested the use of real options (RO) valuations for investments with these characteristics – these investments include, but not limited to, high-tech ventures.

First, Gilbert set the ground rules in order for an investment option to be considered a real option by listing two things that need to take place, at the same time, for real options to exist. These are:

“There must be uncertainty in terms of future project cash flows, and
“Management must have the flexibility to respond to this uncertainty as it evolves” (2004, p. x).

Boer defined real options by making an analogy between real options and financial options (2000). In a financial option

“one can purchase a call option on a common stock. One makes an initial investment to purchase the call. The option may be exercised at a pre-agreed "strike price," which involves a second, but optional investment. The stock is then delivered by the seller of the call and can be liquidated for cash” (Boer, 2000, p. x).

“For example, one might purchase a call on a stock selling at $100 for $5. If the stock rises to $110, one next exercises the call paying $100. If the stock is liquidated, the second transaction nets $10 and the entire transaction $5” (Boer, 2000, p. x).

Furthermore, Gilbert claims that “One of the key differences of the RO approach when compared to the NPV approach from a management perspective is that RO focuses attention on identifying sources of uncertainty and forces management to consider the question of ‘when does a project have sufficient flexibility?’” (Gilbert, 2004, p. x). Hence, the main point in using real options in valuing investments is the techniques used are directly based on the valuation techniques developed and used in financial options pricing. These valuation techniques include “analytical solutions (or approximations) such as the famous Black Scholes model as well as numerical methods such as the Monte Carlo and binomial lattice approaches” (Gilbert, 2004, p. x).

One of the key reasons why NPV, CAPM and other cash flow models have been becoming obsolete in valuing technology-based and related investments is the seemingly widening gap between the cash flow model valuation of a technology stock and the high premium prices. Technology stocks “that are losing money (and hence cannot be valued using price-earnings ratios or multiples of EBIT or EBITDA, and for which there are minimal physical assets, are being valued instead at huge multiples of revenues or projected revenues” (Boer, 2000, p. x). This is in complete contradiction to the principles underlying cash flow-based valuations. For example, in the computation of the net present value of an investment option the investment decision is usually based on how high the net preset value of the investment is which depends on how high the expected future cash flows are.

Another reason is pointed out by Smith and Amoruso (2006). High-tech ventures’ value is based on intangibles (Smith & Amoruso, 2006, p. x) and intangibles are rarely included in computing for a company’s net present value or discounted cash flows. However, with all its advantages as a valuation method, real options model does have its disadvantages. Tiwana, Wang, Keil and Ahluwalia argued that “little field research has been conducted to test whether [management] suffer from systematic biases” in using real options in valuing investments (2007, p. x). The authors, based on their study, concluded that management “associate real options with value only when a project's easily quantifiable benefits are low, but fail to do so when they are high” (Tiwana, Wang, KEil & Ahluwalia, 2007, p. x).

From my readings, I inferred that real options valuation is not a complete avowal from net present value – it is an extension. As a matter of fact, Gilbert says that “[the] valuation of real options starts with the identification of the traditional NPV model” (Gilbert, 2004, p. x) because the NPV model aids in the identification of uncertainties and in the valuation of the real options themselves. From this I can say that using real options is not so difficult because the underlying principles and valuation techniques of the theory are not too complex. From this simplicity, I agree that real options theory is one of the best approaches for valuing new high-tech ventures. However, I believe that this is not the real issue: the valuing technique and tool is not the end, but the means to an end. The real issue here is how the investor synchronizes his business objectives with the investment vehicles he chooses to invest in.
References

Boer, F. P. (2000). Valuation of technology using “real options.” Research Technology Management, 43 (4), 26-30.

Gilbert, E. (2004). An introduction to real options. Investment Analysts, 60 (49).

Smith, G. S. & Amoruso, A. J. (2006). Using real options to value losses from cyber attacks. Journal of Digital Asset Management, 2 (3/4), 150.

Tiwana, A., Wang, J., Keil, M. & Ahluwalia, P. (2007). The bounded rationality bias in managerial valuation of real options: Theory and evidence from IT projects. Decision Sciences, 38 (1), 157-181.