Real Options Analysis
What is a Real Options Analysis?
A real options analysis (ROA) is an investment evaluation method that values flexibility and strategic decision-making in uncertain environments. Unlike traditional approaches, ROA acknowledges that investments often involve a series of choices over time, allowing businesses to adapt, expand, or abandon projects based on evolving circumstances. This approach provides a more dynamic and comprehensive assessment of an investment's true economic potential, especially in projects with high uncertainty.
The Basic Idea
Imagine a company contemplating whether it should invest in a new technology with uncertain market potential. A traditional approach, such as a Cost Benefit Analysis (CBA), might suggest rejecting the project if the expected cash flow doesn’t exceed the upfront costs associated with investing. However, such an analysis overlooks some of the strategic options the company might have. What if the company could delay the investment until they better understand the potential future outcomes? What if they could expand the project if there proves to be a high demand for their product—or abandon the project with minimal losses if it fails to deliver?
For a more flexible approach, this company might want to try a real options analysis (ROA). This method acknowledges that investments often involve a sequence of choices over time, not just a single "go/no-go" choice. As it suggests in its name, a real options analysis allows decision-makers to consider real options, which are the opportunities, but not the obligations, to make future decisions based on how uncertainties unfold. Such options could include deferring, expanding, scaling down, or even outright abandoning a project.1
To conduct an ROA, companies may start by first identifying the real options within their project and then identifying the relevant variables that may impact this option. After estimating the volatility of each asset, a company can then calculate the value of each option using decision-making software or mathematical formulas, incorporating estimates for uncertainties like changing market prices. By assigning a monetary value to these options, ROA provides a more complete picture of an investment's true economic potential.1,2
Real options analysis assumes that the future is uncertain and that management has the right to make midcourse corrections when these uncertainties become resolved or risks become known; the analysis is usually done ahead of time and thus, ahead of such uncertainty and risks. Therefore, when these risks become known, the analysis should be revisited to incorporate the decisions made or revising any input assumptions.
― Johnathan Mun, Real Options Analysis: Tools and Techniques for Valuing Strategic Investment and Decisions, 2nd Edition
About the Author
Annika Steele
Annika completed her Masters at the London School of Economics in an interdisciplinary program combining behavioral science, behavioral economics, social psychology, and sustainability. Professionally, she’s applied data-driven insights in project management, consulting, data analytics, and policy proposal. Passionate about the power of psychology to influence an array of social systems, her research has looked at reproductive health, animal welfare, and perfectionism in female distance runners.
