Definition of real options reasoning

An approach to managing projects under uncertainty that implicitly accounts for the ability of managers to alter and improve these projects as technological and market conditions change. For example, by purchasing a plot of land near its factory now, a firm gains the real option of expanding its factory later.  In determining whether or not to purchase the land, the firm should account for this real option value.

Real options reasoning is a heuristic based on the logic of financial options.  A heuristic is just a rule of thumb by which one makes a quick decision in a complex environment.  The real options heuristic is managers’ recognition that flexibility is valuable, which allows them to choose project decisions that acknowledge this value, even though they cannot precisely calculate its value.

This heuristic is based on the logic of financial options in that financial options are contracts that create valuable flexibility; if you have a financial option, you have the flexibility to purchase, or sell, something at a pre-specified price at a later date, or to go with the market price at that future date.  Like financial options, investments in real assets can provide firms the option to take an action at a later date if conditions are favourable, or to abandon further investment if conditions prove unfavourable.

Example

Many investment opportunities entail real option value.  However, unlike financial options, there is no objective market for most real options. 

To set a price for a financial option, there are a set of variables for which values must be known. Once these values are agreed, a price can be set and two parties can agree a contract - the option of selling/ buying something at a particular price at a specific future date, and the right to do this granted for a specific price (the option premium).

For real options, it is typically not possible to establish these values, nor is it possible to establish a contract.  For example, corporate social responsibility is sometimes characterised as containing real option value. That is, if a manufacturer invests in, say, building a community centre, the goodwill it engenders may earn the firm some flexibility with local regulators, and later it may be allowed to expand its manufacturing facilities.

However, it is unlikely that this goodwill will be in the form of a contract, nor is it clear how much that goodwill is worth at the time the decision is made to build the community centre.  Rather, managers know that there probably is some such value, and they factor this notion, though somewhat vague, into their decision-making. Thus, real options reasoning is best used as a heuristic and not as an explicit valuation tool. [1]