Definition
Real options valuation treats business decisions (expand, delay, abandon, contract) as financial options and uses options pricing models to value this managerial flexibility. Traditional DCF assumes a fixed path; real options capture the value of adapting to new information. This is particularly valuable for R&D-intensive firms, natural resource companies, and startups.
lightbulb Example
A pharma company has a drug in Phase 2 trials. Traditional DCF values it at $200M. Real options analysis values the option to abandon ($0 cost) if trials fail plus the option to expand if successful, yielding $280M—the $80M difference is the option value of managerial flexibility.
verified_user Key Points
- Values flexibility that DCF ignores
- Option to expand, delay, abandon, or switch
- Particularly relevant for R&D and natural resources
- Requires options pricing models (Black-Scholes, binomial)