Today, practitioners start recognising the limitations of the NPV method for valuing businesses. In this page, we present a complementary technique that enhances the traditional NPV approach with the valuation of options that are embedded in the business opportunity, for instance the option to delay the decision to invest, or the option to expand the project. Unlike financial options like call and put on shares, options in business ventures are said to be real because the underlying assets are real business assets as opposed to financial securities.
The Real Options framework has been available since the early 1990s. Although not always easy to put into practice, valuations using Real Options bring new insights into the business opportunity and have been used successfully in a number of industries, for instance in mining and pharmaceutical. We expect that Real Options valuation will find more and more acceptance and become a standard tool in the next decade.
A note of caution before we start: the primary objective when valuing Real Options is to gain new insights as a business manager into a project opportunity, not to produce precise results. Therefore, making meaningful assumptions to simplify and solve Real Options problems is all right and always better than being precisely wrong. Results should always be understood as estimates: Real Options valuations, like NPVs, are based on models that approximate a complex reality.
The NPV assumes that the decision to start a project, as well as all other subsequent decisions, have to be taken at time zero (i.e. now) and these decisions, once taken, are irreversible. More generally, the NPV is based on a number of key premises:
- We can not wait, but have to decide now or never. In reality, many decisions can be postponed, and managers do so, for instance request further analysis, additional R&D or a pilot project before proceeding to a full-blown launch.
- We go into this business, and stay in the business forever. In reality, managers can decide to scale back or abandon operations at a later stage.
- We go into this business, and stick to the original plan. In practice, managers remain flexible to changing market conditions. The NPV assumes that all future investments are pre-committed, whereas in practice this is never the case. Executing a strategy involves making a sequence of major business decisions, not deciding everything on day one. Managers do not follow a pre-determined plan blindly, but do consider and learn from how events unfold.
- We do not go into this business now, and we will never go. In practice, managers who initially decided not to be active in a sector can still decide to play at a later stage, for instance because the market conditions have improved.
The result is that NPVs are fundamentally flawed because they do not take into account the value of management flexibility to adapt to changing circumstances. If the market grows faster than anticipated, it is worth expanding operations. Technology innovation might also open the door to new and unforeseen applications. None of this is captured in the traditional NPV calculation. Real options address this shortcoming: the value to wait before undertaking a major investment, the flexibility to enter a market with options to grow, scale down or abandon, or not enter a market now, but keep the option to participate at a later stage.
The traditional NPV can be interpreted as a “floor”. In the ideal world where the cashflow forecast would be neither positively nor negatively biased, the NPV would still generate conservative results. This is problematic because it does not pay to be too conservative as it might lead to suboptimal decision making and a firm might miss good opportunities.
There is ample empirical evidence that managers do not follow the NPV rule to the letter: investments are often made that can not be justified by the NPV alone, and vice-versa companies often stay in a troubled business longer than an NPV analysis would recommend to do so: shutting down a business leads to an irreversible loss of tangible and intangible capital, and companies want to preserve the right to resume profitable operations later on. Managers’ behaviour also demonstrates that decisions are often taken with an “option” mindset, even if this happens unconsciously: projects which with low or negative NPV are undertaken on the basis that they are “strategic”, which in practice means that they open chances for future businesses. What companies are essentially doing is creating options for themselves and building up know-how for future opportunities.
If the NPV is negative, but close to zero compared to the size of the initial investment required, then this should not be a systematic ‘no-go’. The decision to go ahead might be postponed and investments in R&D undertaken in the mean time to reduce technology risk. Or the project can go ahead now, but investment decision can be staged and performance be reviewed at regular milestones. In addition, uncertainty in market development and management flexibility to react to changes by expanding, contracting or abandoning the project also make today’s project value higher than in the static NPV approach.
In summary, when options and their values are taken into account, in many cases the value of the project with flexibility will be higher than zero, and in some cases substantially so.
In business life, three types of options can be encountered in practice:
- The option to defer an investment decision, in particular when uncertainty in the evolution of market demand is high and the project does not have priority due to limited resources.
- The option to expand an existing business at a later stage. In the initial phase, the business will focus on the most promising product or application and the business or portfolio will be enlarged later to address the remaining growth opportunities.
- The option to close down or sell a business or its assets, for instance when the current market share is too small and the business is more valuable to someone else. This is also called an abandonment option.
The first two types of options can be modelled as call options, the latter option is a put option. In the analysis below, we will focus on call options. Abandonment options usually have low value as assets are company or industry specific, and this makes their exercise price often negligible.
Some will say that the business options that have been identified can be added to the business plan and valued using the traditional NPV approach. But that is the whole point of Real Options: they do not make the identification of options redundant, but help value them correctly as an NPV calculation is not appropriate to value options. The risk profile of an option is different from the risk profile of the project as a whole, so discounting using the project WACC does not value the option correctly. The beauty of the Real Options framework is that it enhances the NPV approach: once the options have been valued, the total value of the business is the sum of the NPV and the value of the options.
Total NPV = NPV (without options) + Value of Options
Note that when the base cashflow forecast already includes an embedded option, the cashflows need to be restated by excluding the option cashflows and the option has to be valued using a separate technique. Only then can the value of the option be added back to the value (NPV) of the project without the option.
For more information about ‘Real’ options and how to apply them in practice, feel free to contact us.