Friday, December 10, 2004

Total Value = NPV + Real Options

After having been introduced by Timothy Luehrman in 1998, real options have had a difficult time catching on with managers. Often managers find options formulas too complex and some CFOs believe the method causes overvaluation of risky projects. This concern can be legitimate, but abandoning real options as a valuation model alltogether is also not the solution, according to Alexander B. van Putten and Ian C. MacMillan (HBR Dec04). They (correctly) state that companies that rely solely on discounted cash flow (DCF) analysis underestimate the value of their projects and may fail to invest enough in uncertain but highly promising opportunities.

Van Putten and MacMillan recommend business valuators and CFOs should not choose one approach over the other. Real Options are not a replacement for DCF analysis, but a project's total value should encompass both NPV and Real Options.

In a Formula:
Total Project Value = Net Present Value + Adjusted Option Value + Abandonment Value.

Their final advice is certainly also valuable when working with Real Options (as also any investor in financial options will confirm): option valuations only make sense when applied to projects that can AND ARE terminated early at low cost if things don't go well. No valuation method will save a company that does not actually pull out quickly, if a project fails to deliver on its initial promises, and redeploy their talent and capital elsewhere.