In Finance, what is a Real Option?

Real option analysis (ROA) is a decision-making framework that calculates the value of a future business decision. ROA borrows from financial options theory. A financial option gives the buyer of a financial asset the right, but not the obligation, to purchase a stock or bond, for example, at a predetermined price at a future date. By analogy, a real option is a managerial decision-making tool that calculates the value of a business decision that a manager has an option, or right, but not an obligation to fulfill.

Options analysis is a form of decision-tree analysis that can be used to manage and reduce uncertainty, or risk, in business decisions. By considering options A and B, for example, real options analysis maps out various scenarios branching out from each option. Also known as scenario analysis, the decision-maker is able to make better informed decisions based on the estimated value of each scenario, or point, on the tree.

In the capital markets, real option analysis migrated from the analysis of investment instruments to corporate finance where it is used in capital allocation decisions, such as deciding when to acquire new businesses or divest of assets. This evaluation tool is applied in all areas of business decision-making to assess managerial and strategic options. In the United States government, the National Renewable Energy Laboratory uses real options to assess the financial, technological, and market risk of different renewable energy technologies. The option to invest in wind or solar power in various regions of the country may be evaluated based on weather conditions, such as wind and sun intermittency, and future energy prices and policy.

By providing a range of values at specific points in the future, real option analysis provides information on the optimal time to make a business decision. In evaluating the long-term viability of a money-losing business division, a manager may have the options of selling the business, divesting of assets, closing down an unprofitable product line, or downsizing the workforce. A manager should be able to evaluate how each of these options affects the division’s profitability in three months, one year, or two years.

Real option analysis can provide real value in business scenarios when data is sparse or outcomes highly uncertain. A strength of real option analysis is the robust analytical tools it borrows from the financial markets, which can greatly enhance the information available for decision-making. Monte Carlo analysis, for example, is commonly used to make decisions when there is higher risk of unexpected price spikes due to exogenous shocks.

An oil embargo in the energy markets is an example of an unexpected geopolitical event that could increase energy prices. By business analogy, an oil refinery operating in a high-risk hurricane region may apply real option analysis to make operational decisions based on the scenarios of business as usual or the risk of being completely shut down. In this scenario, real option analysis is further valued for its ability to assess the probability of an uncontrolled event — the highly unpredictable pattern of Mother Nature.