Let’s look at 2 cars: Same brand, model, engine, color. Condition: Brand new. One difference: Car 1 runs only on gas. Car 2 runs primarily on gas but gives you an option to easily connect an electrically charged battery in future.
Now if you were asked to buy either car for the same price, which one you would choose? Car 1 or Car 2? Definitely Car 2! Even if you are not going to use the electrical battery now, you would definitely like the option! So you automatically do the mental calculation of giving Car 2 a higher total value than Car 1, by pricing in the availability of an option you might want to exercise at some point in future.
This is exactly what a real option is! If you naturally tend to assume the higher value of a future option in the above case of cars, would you ignore such an option if the cars were replaced by businesses that you are looking to purchase or invest in?
Now, how much extra would you be willing to pay for Car 2 over Car 1? This extra amount is actually the value of the real option.
Real options and its types
Simplistically speaking, a real option provides a business with a right to choose an alternative, at a pre-determined cost (exercise price), and at a pre-defined timeframe in future (time to expiration). This is relevant to both financial and strategic business decisions. The option is called ‘Real’ because it deals with tangible assets like land or other capital equipment and not financial instruments.
Real options are essentially of three types:
- An option to expand or scale up – say, if you test market a product and find that it has great potential, you would exercise the option to commercially launch it as soon as possible
- An option to withdraw – again, if the test market result is negative, you might want to completely abandon your investment or scale down such a project
- An option to delay a decision – this basically allows you to buy time to be able to defer a decision till when you are in better and more favorable market situation
Traditional NPV vs. Real Options Approach
Real options present your business with an opportunity to delay decision-making to some point in the future. This is a very valuable opportunity in my opinion and should not be ignored.
Say, you are a pharmaceutical company investing in R&D for a number of drugs, which are in various stages of development. You take a ‘Go-No Go’ decision for each drug at the end of every phase of development. This gives you the flexibility to decide whether it is financially viable and profitable to continue with the development of that drug – based on the results of the previous phase. In essence, this is a real option that you have; whether to abandon a project or not?
For any pharmaceutical company this pipeline of drugs and the patents it owns are the most important assets. But if you analyze the R&D expense with the standard DCF method, the negative NPV will suggest it is a bad investment! Only when you consider the future opportunity of successfully commercializing the pipeline into products, does it begin to make any financial sense. Now, the question is, how do you want to incorporate these in the valuation of the company? Should you use the traditional NPV approach or the Real Options approach?
Let’s take a real life example – Biogen received FDA approval for Avonex, a blockbuster drug to treat multiple sclerosis. Based on the NPV approach, the value of this patent was USD 547 million. However, when valuing this using the real options approach, its value was USD 907 million, implying a ‘time premium’ of USD 360 million. This time premium results from the fact that the management will get time to react to various changing market situations.
So as an investor, if you had valued the patent for just USD 547 million instead of USD 907 million, you would have very much under-estimated Biogen’s enterprise value and probably taken a wrong investment decision!
I am not at all suggesting that you should completely forget or discard the NPV approach for business valuation. However, as the business environment is becoming more and more complex and dynamic, the traditional approaches seem to be inherently static and constrained. The real options approach is not only more flexible, but it also allows you to take competitive strategies into account. Hence you need to complement the traditional valuation techniques with the real option approach of valuation, especially, in case of companies or sectors which tend to derive a large part of their value from these future possibilities.
– Research Optimus