Taking Real Options Beyond the Black Box

Finance theorists have long argued that DCF undervalues investment opportunities with significant flexibility to respond to future events and that real options valuation methods provide a solution to that problem. But for most corporate managers, real options analysis continues to be a “black box” when applied to real investment decisions. This paper begins by considering why these approaches have not yet made it to the mainstream of practical application. It then shows how a traditional DCF approach can undervalue a project that provides management with operating flexibility and illustrates a case study that demonstrates to senior management how a real options valuation method with a few clear value drivers can build upon and be made consistent with the traditional DCF framework. Critical to this process is ensuring consistency with the company's planning assumptions such as future price forecasts and discount rates. The article shows how to separate the static (“optionless”) DCF value from the additional real options value that is shown to be a direct consequence of the assumptions about price dynamics.