The New Valuation Paradigm: Real Options

Conventional capital budgeting techniques such as the discounted cash flow analysis fail to recognize managerial flexibility that may have a huge option value. Such managerial flexibility may include abandonment option, option to defer development, option to expand, option to contract, and switching options. Though the extension of option pricing theory to valuation of other assets is not a novel concept, it has become increasingly popular with the new economy frenzy. Unable to justify the strikingly high market valuations of technology stocks with orthodox techniques, academics and market professionals have started to exploit option pricing technologies that presage relatively much higher valuations, which are indeed justifiable for highly flexible and high-growth companies. Nevertheless, these valuations are also highly sensitive to initial conditions and exact specification of parameters, which can be a viable explanation for the relatively much higher volatility of returns for Internet stocks. Regardless of the discussion whether it makes sense to use real options in order to justify high market valuations, the real option methodology is indispensable in recognizing the managerial flexibility, which may be inherently embedded in any capital budgeting project. * Istanbul Commerce University, Faculty of Commercial Science.