Real Option valuation model

Option pricing model was created originally to determine a financial option price. The most generally accepted option pricing model is the basic model by Black and Sholes and the alternative model for option pricing is the binomial model. Both models are based on the same theoretical foundations and assumptions (such as the geometric Brownian motion theory of stock price behavior and risk-neutral valuation).

Black and Sholes, binomial model

Real option is an actual option (in the sense of “choice”) that a business may gain by undertaking certain endeavors. The real option captures the value of managerial flexibility to adapt decisions by expanding, downsizing, or abandoning investment projects in the future in response to unexpected market developments. In this context, real option valuation model applies basically the same theory and calculation formula as the financial option pricing models to quantify the value of management flexibility in a world of uncertainty.

Real option valuation

The main idea of the real option valuation model is that companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project. The real option represents the new state-of-the-art technique for the valuation and management of strategic investments and enables corporate decision-makers to leverage uncertainty and limit downside risk. Therefore, the valuation methods model using real option provides a fair value of a company in particular under significant uncertainty and high risk while traditional valuation models such as DCF model fail to accurately capture the economic value of investments or company in an environment of widespread uncertainty and rapid change. However, one main disadvantage of the real option valuation model is that it is difficult to calculate and the calculation is a time-consuming hard work without the help of computer.

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