Transactions Blog

When confronted with a situation where the “standard” NPV is inappropriate (see article – Part I), one should first identify all the value drivers and the key elements of the business plan for which uncertainty is high. It should then identify all the options for which it has either to mitigate these uncertainties or to react upon their resolution: the option to postpone the investment, to downsize production capacity, to close down capacity, to exit, to increase capacity, to transform itself into another business, etc.

The difficulty in this process is to find the relevant options, the ones bringing value to the project – the ones for which undertaking a real option valuation approach will be worthwhile.

The fact that management can stop a research project whenever the results of a test are negative, that uncertainty about the success of a research programme is high and that the NPV of such a programme is close to zero clearly indicates that a real option valuation approach should be used. The three conditions discussed in the previous article are met. Starting research on a chemical formula today is effectively an option that gives the right to make pre-clinical trials in a few years. These pre-clinical trials are nothing else but a further option giving the right, if they are successful, to make clinical trials. The clinical trials in turn provide yet another option to invest in a production process if they turn out to be positive. Today, valuing research programmes as a portfolio of compounded options is the best way to estimate the real value of an R&D programme.

In the same way, the portfolios of Venture Capital funds providing “seed capital” should be looked at as portfolios of real options. Investing a “small” amount of money in a start-up provides such funds with an opportunity to know more about the business, the management and to invest in a second and third stage if the project turns out to evolve as foreseen or better than foreseen.

The methods used to value real options are based on the groundbreaking work of Black and Scholes, who developed a formula to value financial options on stocks paying no dividends in the 1970’s. Since then, their work has been further developed by other academics and researchers to encompass the valuation of many kinds of different options. Black, Scholes and Merton originally showed that the value of a financial option on a share was dependent upon six parameters: the life of the option, the exercise price, the share price, the volatility of the return of the stock, the risk free rate and the dividend yield.

Real options are similar to financial options. The difference is that the asset underlying the option is not a quoted security but a “fixed” asset. The six key parameters affecting the value of a real option become therefore: the life of the option, the investment to be made (the purchase price of the asset), the present value of the future cash flows generated by the asset, the volatility of the return of the project, the risk free rate and the cost of keeping the option alive.

These six parameters can then be used in the Black & Scholes formula to compute an estimate of value when the option cannot be exercised before its expiry (maturity) or when the cost of keeping the option alive is null. When none of these two conditions is met, other methods such as binomial trees or Monte Carlo analysis for instance, should be used.

The complexity of the computation should not refrain investment analysts from using this approach, as it is probably the only one that will capture correctly the value of management flexibility. And it is not uncommon to see estimates of option values reaching 30% of the present value of the projected future cash flows, in cases in which a “standard” NPV analysis would indicate a zero value.

As we are living in a world changing at an ever-faster pace, uncertainty is increasing and will increase further in almost all business sectors. The investment decision process will therefore require a more frequent use of the real option methodology, starting right at the moment when the company defines its strategy. Firms understanding this and applying the real option concept will therefore build a new kind of competitive advantage.

How should a firm and its management evidence its decision to invest in a company, in new equipment, in new projects, in new markets? Most of us have learned at some point in our education that such a decision should be based on financial analysis, looking at the payback period, at the internal rate of return or better, at the Net Present Value of the project. We have been taught that we should invest if the Net Present Value (NPV) of the project is positive. Yet many readers will agree with me that in “real life”, projects with a “high” internal rate of return happen to be postponed and that for “strategic reasons”, projects happen to be undertaken when their NPV is negative. And, after all, sometimes these decisions appear to have been the good ones…

So, are the decision tools we were provided with the right ones? Are we missing something? Should we forget NPV to assess our investments and rely on “strategy”, “vision” and “business flair” only?

No ! Tools such as NPV were developed at a time when technology and market developments were evolving at a slower pace than at the beginning of the 21st century, at a time when uncertainties about future prices, sales volumes and regulations were lower than today. These tools have been useful and remain useful in many situations. In some circumstances, however, their use can lead to inappropriate decisions. The key issue for management is to identify when this might happen and in these cases to use better, more appropriate tools.

The NPV approach generally supposes that an irreversible investment is made at some point in time and assumes, in its standard form, a constant business risk. It does not consider the timing of the investment as a parameter. In other words, it does not take into account the fact that postponing an investment provides an opportunity to learn more about the uncertainty of some of the project variables.

A company with an investment project is a company holding a “call option”, a right (but not an obligation) to invest in an asset at some point in the future. When the decision to invest is taken, the option is “killed” and the company gives up on the possibility of learning more about the uncertainties surrounding the project. This lost option value is an opportunity cost that is not captured by  “standard” NPV, but which should be taken into account when making an investment analysis.

Scholars have shown that the “standard” NPV approach is inappropriate when the following conditions are present:

• The “standard” NPV of the project is close to zero or is negative;
• There is a high uncertainty on some of the key value drivers of the projects and the NPV is sensitive to these value drivers;
• Management can react on the resolution of the uncertainties (switch from one production process to another, delay investments, reduce capacity, increase capacity, etc).

When these three conditions are met a Real Option valuation approach is recommended as it will fully capture the optional characteristics of an investment and should lead to a better decision taking process.

The above conditions are usually present in companies investing heavily in R&D (pharmaceutical companies, biotechnology companies), in start-ups (seed capital Venture Capitalists), in natural reserves (oil companies), etc. Today however, in an environment that is changing at an ever-faster speed, these conditions are also beginning to be met in numerous other sectors.

[to be continued – Part II ]