Real Option: Definition, Valuation Methods, Example

What Is a Real Option?

A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financial instrument.

Real options differ thus from financial options contracts since they involve real (i.e. physical) "underlying" assets and are not exchangeable as securities.

Key Takeaways

  • A real option gives a firm's management the right, but not the obligation to undertake certain business opportunities or investments.
  • Real option refer to projects involving tangible assets versus financial instruments.
  • Real options can include the decision to expand, defer or wait, or abandon a project entirely.
  • Real options have economic value, which financial analysts and corporate managers use to inform their decisions.

Understanding Real Options

Real options are choices a company’s management gives itself the option to make in order to expand, change, or curtail projects based on changing economic, technological, or market conditions. Factoring in real options affects the valuation of potential investments, although commonly used valuations fail to account for potential benefits provided by real options.

Using real options value analysis (ROV), managers can estimate the opportunity cost of continuing or abandoning a project and make better decisions accordingly.

It is important to note that real options do not refer to a derivative financial instrument, such as call and put options contracts, which give the holder the right to buy or sell an underlying asset, respectively. Instead, real options are opportunities that a business may or may not take advantage of or realize.

For example, investing in a new manufacturing facility may provide a company with real options for introducing new products, consolidating operations, or making other adjustments in response to changing market conditions. When deciding whether to invest in the new facility, the company should consider the real option value the facility provides. Other examples of real options include possibilities for mergers and acquisitions (M&A) or joint ventures.

Real Options Valuation

The precise value of real options can be difficult to establish or estimate. For instance, real option value may be realized from a company undertaking socially responsible projects, such as building a community center. By doing so, the company may realize a benefit that makes it easier to obtain necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits. 

In dealing with such real options, a company’s management team factors the potential for real option value into the decision-making process, even though the value is necessarily somewhat vague and uncertain. Of course, the key difference between real options and derivatives contracts is that the latter often trades on an exchange and has a numerical value in terms of its price or premium. Real options, on the other hand, are far more subjective. But, by using a combination of experience, and financial valuations, management should get some sense of the value of the project being considered and whether it's worth the risk.

Still, valuation techniques for real options do often appear similar to the pricing of financial options contracts, where the spot price or the current market price refers to the current net present value (NPV) of a project. The net present value is the cash flow that's expected as a result of the new project, but those flows are discounted by a rate that could otherwise be earned for doing nothing. The alternative rate or discount rate might be the rate of a U.S. Treasury bond, for example. If Treasuries pay 3%, the project or the cash flows must yield a return of more than 3%; otherwise, it wouldn't be worth pursuing.

Some valuation models use terminology from derivatives markets wherein the strike price corresponds to non-recoverable costs involved with the project. In the derivatives world, the strike would be the price at which the options contract converts into the underlying security that is based on. Similarly, the expiration date of an options contract could be substituted with the time-frame within which the business decision should be made. Options contracts also have a volatility component, which measures the level of risk in an investment. The higher the risk, the more expensive the option. Real options must also consider the risk involved, and it too could be assigned a value similar to volatility.

Other methods of valuing real options include Monte Carlo simulations, which use mathematical calculations to assign probabilities to various outcomes given certain variables and risks.

Special Considerations

Heuristic Reasoning

Real options analysis is still often considered to be a heuristic—a rule of thumb, allowing for flexibility and quick decision-making in a complex, ever-changing environment—based on sound financial criteria. The real options heuristic is simply the recognition of the value embodied in the flexibility of choosing among alternatives despite the fact that their objective values cannot be mathematically determined with any degree of certainty.

Even if a quantitative model is employed to value a real option, the choice of the model itself is based on judgement and often a trial-and-error approach since the choices available can vary across firms and project managers.

Having options affords the freedom to make optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management choices to make investments can give companies real options to take additional actions in the future, based on existing market conditions.

In short, real options are about companies making decisions and choices that grant them the greatest amount of flexibility and potential benefit regarding possible future decisions or choices.

Choices that Fall Under Real Options

The choices that corporate managers face that typically fall under real options analysis are under three categories of project management.

  1. The first group are options relating to the size of a project. Depending on the ROV analysis, options may exist to expand, contract, or expand and contract the project over time, given various contingencies.
  2. The second group relates to the lifetime of a project—to initiate one, delay starting one, abandon an existing one, or plan the sequencing of the project's steps.
  3. The third group of real options involves the project's operations: the process flexibility, product mix, and operating scale, among others.

Real options are most appropriate when the economic environment and market conditions relating to a particular project are both highly volatile yet flexible. Stable or rigid environments will not benefit much from ROV and should use more traditional corporate finance techniques instead. Similarly, ROV is applicable only when a firm's corporate strategy lends itself to flexibility, has sufficient information flow, and has sufficient funds to cover potential downside risks associated with real options.

Real-World Example of Real Options

The McDonald's Corporation (MCD) has restaurants in more than 100 countries. Let's say the company's executives are mulling the decision to open additional restaurants in Russia. The expansion would fall under the category of a real option to expand. The investment or capital outlay would need to be calculated, including the cost of the physical buildings, land, staff, and equipment.

However, McDonald's executives would need to decide if the revenue earned from the new restaurants will be enough to counter any potential country and political risk, which is difficult to value.

The same scenario could also produce a real option to wait or defer opening any restaurants until a particular political situation resolves itself. Perhaps there's an upcoming election, and the result could impact the stability of the country or the regulatory environment.

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