Valuation: Packet 3
Real Options, Acquisition Valuation
and Value Enhancement"
Aswath Damodaran
Updated: January 2012
Aswath Damodaran
1
Real Options: Fact and Fantasy"
Aswath Damodaran
Aswath Damodaran
2
Underlying Theme: Searching for an Elusive Premium"
Traditional discounted cashflow models under estimate the value of
investments, where there are options embedded in the investments to
• Delay or defer making the investment (delay)
• Adjust or alter production schedules as price changes (flexibility)
• Expand into new markets or products at later stages in the process, based upon
observing favorable outcomes at the early stages (expansion)
• Stop production or abandon investments if the outcomes are unfavorable at early
stages (abandonment)
Put another way, real option advocates believe that you should be
paying a premium on discounted cashflow value estimates.
Aswath Damodaran
3
A bad investment…"
+100
Success
1/2
Today
1/2
Failure
-120
Aswath Damodaran
4
Becomes a good one…"
2/3
+80
+20
1/3
1/3
Now
-100
2/3
-20
Aswath Damodaran
STOP
5
Three Basic Questions"
When is there a real option embedded in a decision or an asset?
When does that real option have significant economic value?
Can that value be estimated using an option pricing model?
Aswath Damodaran
6
When is there an option embedded in an action?"
An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.
There has to be a clearly defined underlying asset whose value changes
over time in unpredictable ways.
The payoffs on this asset (real option) have to be contingent on an
specified event occurring within a...