Date posted: 30/11/2020

Advanced valuation techniques – real options

Deciding when real options apply and when they are most valuable is a critical part of business valuation.

In brief

  • Stephen Reid FCA presented an advanced valuation session at the 2020 CA ANZ Business Valuation conference
  • The session covered real options theory and provided a practical workshop in the binomial pricing method
  • The key messages from his interactive presentation are summarised in this article, and other content from the conference is available to purchase online

Valuations Partner at Deloitte and CA Business Valuations Specialist Stephen Reid FCA took participants at the 2020 Chartered Accountants Australia and New Zealand Business Valuation conference through an intensely practical session on applying real options, giving them hands-on experience in this advanced valuation technique.

The theory of real options

Businesses wanting to make a decision about ongoing projects or potential investment opportunities have a range of 'real options' from which to choose. Using the seven s's, businesses can identify their growth, deferral or quit options.

There are three real options for businesses looking to invest and grow – scale up, switch up or scope up. Another real option, often employed by the resources industry when commodity prices are low is 'defer and learn', which delays investment until more information or skill is acquired.

The final set of options, 'disinvest or shrink', involves scaling, switching or scoping down when the business limits its scope or abandons operations.

Real options and pricing

Reid summarised the three approaches to pricing options:

  • analytical solutions derived from partial differential equations with boundary conditions
  • the binomial pricing model
  • numerical methods, for example, the use of the Monte Carlo simulation.

He said that all three methods could derive the same answer under the right circumstances but valuers may prefer to use one over the other depending on the situation.

The practice – binomial pricing

Reid then focused on the second pricing approach, binomial models, starting with some formulas to master the mathematical component. Participants were set a 45-minute task to evaluate a proposal to expand an imaginary company's manufacturing facilities.

The proposal involved a second-stage investment in improvements in process technology, with an unattractive NPV. Participants worked in groups to review the cash flows to bring insights to how management could assess such an opportunity.

"All three methods could derive the same answer under the right circumstances but valuers may prefer to use one over the other depending on the situation."

After working in breakout groups, participants regrouped to discuss their findings and work through the questions together. The session ended with some insights about when real options apply, and when they are most valuable.

Access Business Valuation conference recordings online

This article highlights the key messages from this practical interactive session.  Due to the interactive nature of the session, we are not able to offer it as a webinar for members who missed the live conference.  However, the lecture-style presentations from the Business Valuation conference are now available online as a recorded webinar, including Aswath Damodaran's keynote address.

Find out more (AU) Find out more (NZ)

Wisdom of the Jedi: Professor Aswath Damodaran

Professor Aswath Damodaran was keynote presenter at the 2020 CA ANZ Business Valuation conference.

Read more

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