The development and use of derivative securities in the financial markets has become more and more common in recent years. And while the mathematical models employed in derivative construction and pricing can seem intimidating, investors may be surprised to learn that these complex investment vehicles are not confined within the walls of a centralized exchange - in fact, so-called "real options" occur quite frequently in the business world, and they can play an important role in stock price determination. Here we explain what real options are and how real-option pricing works.

What Is a Real Option?
First things first: a real option is not a derivative instrument, but an actual option (in the sense of a "choice") that a business may gain by undertaking certain endeavors. A real option gives you the right, but not the obligation, to undertake a specific action at a specified cost over a predetermined time period. This definition may seem convoluted, but rest assured, real options are actually rather simple, and they predate many aspects of today's financial marketplace.

In their book "Real Options" (2001), Tom Copeland and Vladimir Antikarov give a straightforward example of an early real option in action. They recount the ancient Greek philosopher Aristotle's story of Thales (another philosopher), who predicted that the upcoming year's olive harvest would be a record-breaking bumper crop. Thales then offered to pay a hefty sum to the local olive refiners for the right (but not the obligation) to rent the entire olive pressing facility for the standard fee for the duration of that year's harvest season.

As it turned out, Thales' prediction proved accurate, and as the record-breaking olive crop poured in, producer demand to use the olive refining facilities soared. Of course, with sky-high demand, much higher fees could be charged for the use of the olive presses. Fortunately for him, Thales had purchased his real option to rent out the olive presses at a fixed price - he had the right, but not the obligation, to exercise his contract to rent the facility for the standard price. By exercising his real option, Thales was able to profit greatly from the bumper crop, since the olive press owners were obligated by the real option contract to follow through on their agreement and rent the facility to him at the specified price, while he turned around and subletted it for a very high premium.

A Simple Real Option Example for Real Estate
With that history lesson out of the way, let's focus on some more up-to-date uses of real options. Here's a good example of a real option that any homeowner can relate to. Let's say you're shopping for your new residence and you stumble upon what seems to be your dream home: a spacious, new property in a good neighborhood that's selling at a very attractive price because the owners are moving to another country and need to liquidate their home quickly.

The only problem is that the owners' bargain offer has already drawn numerous interested buyers who are prepared to make an offer and close the sale, and you still need to arrange financing before you can make your offer. If you wait for your bank to confirm your financing, you will probably lose the home to another buyer - a real predicament.

This is where the concept of a real option comes into play. You could offer to pay the owners $1,000 to hold the property for you for two weeks. By doing so, you buy yourself the right, but not the obligation, to purchase the home at the offering price any time in the next two weeks once your financing comes through. If it doesn't come through, or if you change your mind about the house, you can simply let the option expire worthless after two weeks. Either way, the sellers keep the $1,000, and since they have numerous other buyers in the wings, they have little to lose by accepting $1,000 to delay the sale of their home for two weeks.

Real Options Valuations and Stock Prices
As we've illustrated in these two examples, the appeal of real option models is their ability to assign a positive value to uncertainty - a fixed price can be paid for the right to profit from a bumper olive crop, for example, but that right need only be exercised if it proves profitable. The classic modern business example is valuing the drilling rights for an oil field. The owner of the rights can opt to exercise them whenever oil prices rise enough to make drilling worthwhile. Given the unpredictable nature of oil prices, sitting on an option that might make money is in itself worth money - even though oil prices may never rise enough to cover the costs of drilling and return a profit, the opportunity to profit if prices do rise is still worth paying for.

Thus, when an oil and gas company buys the drilling rights for a particular piece of land, it is essentially buying a real option, giving it the right (but not the obligation) to undertake drilling when it is profitable to do so. If oil prices plummet, the company can choose to not exercise its option and thus not drill for oil.

Turning to the stock market, remember when the technology boom was reaching its peak? Analysts at the time were using real options to value Internet and biotech stocks; buying shares of an internet retailer such as was like buying an option on the many ways the company might grow in the future. Real options account for the "what if" factor. What if Amazon starts selling clothes online? If it does, then Amazon's decision is the equivalent of exercising a call option to enter this new line of business.

The argument is that a growth company can be treated as a portfolio of real options, the value of which represents what is possible beyond today's business operations. By incorporating what may arise years later into the stock price's information, real options offer a more sophisticated alternative to plain old discounted cash flow (DCF) analysis.

Real Problems with Real Options
The idea that investors can place a value on "what ifs" is definitely exciting. Unfortunately, when applied to stock valuations, the real option method has some serious shortcomings.

First of all, the technique used to value real options is complicated. A decision tree must be plotted, showing the different scenarios that could develop for a company at various stages in its life. A probability rate and a discount rate are attached to each scenario, and the projected cash flows generated from each scenario are then discounted back to the present. The option model then assigns a value to these possibilities using a version of the Black Scholes model, a complex mathematical formula devised in the 1970s for financial derivatives.

Despite such a formidable pricing formula, option valuation is fairly straightforward in fast-moving markets such as the forex markets, where prices are liquid and trading is continuous. But options become more difficult to value when they are written on less liquid underlying assets, such as commodities and real estate. And valuation becomes onerous - if not impossible - when it comes to growth stocks with assets that have yet to be realized.

People are good at estimating speeds and distances, not probabilities. Options can only be priced on a decent estimate of future probabilities. The mathematical sophistication of the real-option pricing model doesn't compensate for the fact that the key data that goes into the formula - namely the assumed probabilities of various favorable outcomes - are invariably pulled out of thin air. So, while real options have some theoretical validity and can be relatively simple to value in simple situations, the approach is probably better suited to a company deciding on its strategy than to an investor picking stocks.

Furthermore, real-option pricing does not necessarily make the important distinction between what is possible and what is doable. The fact that a company has certain options does not guarantee that they will be exercised wisely. The company must have the management skills and the wherewithal to exploit options; moreover, an option doesn't have much value if it cannot be funded.

At the height of the tech bubble, real option pricing was used more as a way of rationalizing prices than predicting them. For instance, tech analysts used options theory to explain the discrepancy between the arguably inflated trading prices seen at the time and the more conservative share values generated by DCF analysis.

The Bottom Line
Generally speaking, investors have a tough time trusting real-option pricing as a valid method. It is hard to swallow the notion that a company's value is based on its as-yet undiscovered potential for generating cash flow later on. Investors have enough trouble accepting net present value based on DCF, let alone the Black Scholes formula.

On the other hand, real-option pricing has opened up investors' minds to new ways of thinking about companies. The real options approach makes investors think about hidden assets, and in relatively simple situations, real options can prove a valuable tool for an investor considering a business opportunity - be it purchasing a piece of real estate or determining the fair value of a potential investment in common stock. While it is a mistake to bet too much on uncertainty, it is also a mistake to forget it altogether.

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