To be sure, many discussions that go beyond the conceptual level get bogged down in the mathematics of Black-Scholes valuation. The reason may be that options theory is notoriously arcane.
So why is it that real options-despite their apparent relevance in business decisions and the fact that they are attracting growing support in academia-have not been recognized or applied by other companies, particularly in industries characterized by high levels of R&D, manufacturing, and marketing investment? Because each of these choices creates a set of payoffs linked to further choices down the line, all management decisions can be thought of in terms of options. But companies in every type of industry have to allocate resources to competing opportunities whether in existing businesses or new ventures, they have to decide whether to invest now, to take preliminary steps reserving the right to invest in the future, or to do nothing.
Indeed, our work in the energy sector reveals that a number of excellent performers do instinctively or intuitively view their investment opportunities as real options, positioning themselves to tap possible future cash flows without making a final decision to invest until the potential is confirmed. The value of keeping one’s options open is clearest in investment-intensive industries, such as oil extraction, in which the licensing, exploration, appraisal, and development processes fall naturally into stages, each pursued or abandoned according to the results of the previous stage. 'The pricing of options and corporate liabilities,' Journal of Political Economy, 1973, Volume 81, Number 3, pp. and specifically on the observation by Stewart Myers of the Massachusetts Institute of Technology that Black-Scholes could be used to value investment opportunities in real markets-the markets for products and services. Fischer Black, who died in 1995, was mentioned in the award citation. Myron Scholes and Robert Merton were awarded the 1997 Nobel Prize in economics for their financial-options valuation model. This case builds on the model developed for financial options by Fischer Black and Myron Scholes as modified by Robert Merton, 1 1. The managers reevaluated the company’s portfolio, and instead of letting blocks go for a notional amount, they decided to hold on to those with high option value and to sell or trade the rest at their revised worth.
#Real options valuation examples how to
In other words, the managers should apply the notion of options, as conceived in financial markets, to their own business situation.Ī simple financial model showed the company’s managers how to price blocks at their option value over five years, incorporating uncertainty about the size of the reserve and oil prices and leaving room for a flexible response to the outcome.
Left with unwanted blocks that were consuming cash (albeit very little) and that had limited investment appeal, the company decided to sell them to other companies that would buy them, cheaply, for reasons of geography or strategic fit.Īt one point in the divestment program, it was suggested to the company’s managers that, instead of calculating what the blocks would be worth if the company started developing them immediately, it should value its opportunity as an option to develop if, at some point in the future, recoverable reserves could be increased through the use of new drilling and production technologies. Where the blocks proved uneconomic-as most did, usually because development costs were too high in relation to expected revenues-development was shelved. Where net-present-value (NPV) analysis suggested that the economics were positive, the company drilled and developed the blocks.
#Real options valuation examples license
Over 30 years of operation, one North Sea oil company accumulated a portfolio of license blocks-five-year rights to explore and produce oil and gas.
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