Real Options Valuation

Real options valuation, also often termed real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right — but not the obligation — to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively. Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security.

Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to "real-life" decisions. For example, R&D managers can use Real Options Valuation to help them allocate their R&D budget among diverse projects; a non business example might be the decision to join the work force, or rather, to forgo several years of income to attend graduate school. It thus forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation.