In Finance, What Is a Real Option?

Real options are an option, and the underlying securities are real commodities that are neither stocks nor futures. Also called equity options and index options. It is a flexible investment strategy that managers have when making decisions on their own physical assets.

Real option

(finance)

Real options ( real options ), which introduce the rules of financial markets into the strategic investment decisions of an enterprise, are used to plan and manage strategic investments. In a market environment where the company faces uncertainty, the value of real options comes from the company's strategic decisions.

Features of real options:

Real options are implicit in investment projects. Some project options have a small value and some project options have a large value. This depends on the uncertainty of the project. The greater the uncertainty, the greater the option value. ^[1]

What this book is going to discuss is a classic problem, namely, how to conduct resource allocation and project evaluation under uncertain conditions; in particular, how to value the flexibility and strategic interaction of business management as real options. Similar to options issued for financial securities, assets are obtained or exchanged at a predetermined optional price. Real options include the right to make decisions based on specific circumstances without the obligation to perform decisions. The ability to evaluate real options (eg, postponing, expanding, contracting, abandoning, switching uses, or otherwise changing the direction of investment) in the field of resource allocation in modern companies has revolutionized.

The key factors that determine the company's value creation and competitive position are the company's resource allocation and appropriate evaluation of various alternative investment options. In recent decades, American companies are gradually losing their competitive advantage relative to their Japanese and German counterparts, although they have used some "stronger" quantitative analysis methods, such as discounted cash flow (DCF) method. In the academic field and the actual management level, more and more people have realized that the various standard methods of company resource allocation have become invalid. The main reason is that they cannot properly grasp the flexibility of managers to adjust and correct subsequent decisions when responding to unforeseen market changes, they cannot grasp the strategic value generated by a proven technology, and they cannot grasp Interdependence and competitiveness between projects. In a rapidly changing and uncertain global market, the management flexibility and strategic adaptability possessed by managers have constituted the key to whether it can accurately utilize future investment opportunities, limit reverse market changes and losses caused by competitive activities . Companies are increasing flexibility and

The concept of real options was originally developed by Stewart Myers (1977) at MIT.

The most common and classic method for investors to directly evaluate the value of an investment project or enterprise for a long time

Real options have been proposed from the beginning, and people have found that it has incomparable advantages of traditional DCF method in application and project investment decision-making. With the development of option pricing theory, especially the introduction of the BS formula, real option theory has been used more and more widely in investment decision-making and value evaluation. On the contrary, the shortcomings of the traditional DCF method have been criticized by more and more scholars and investors.

After more than 20 years of development and practice, the real option theory has formed a relatively complete theory

An option is a special contractual agreement that stipulates that the holder is on a given date or any time before that date

The research of real options is still in its infancy in China. The research of domestic scholars mainly involves the pricing of real options and the impact on strategic management. In terms of specific applications in different fields, it attempts to analyze the differences between real options and financial options in the actual operation and application process from the perspective of the input of financial option pricing models and the characteristics of real options. In order to improve the accuracy of management using real option theory.

From the above table, we can analyze the differences between the two in order:

(A) for

A binomial model is a valuation model that is based on a simple description of changes in the value of the underlying asset, which assumes that at each time period, the change in the value of the underlying asset can only take one of two possible outcomes: an increase A certain percentage point or a certain percentage point. For example: assuming the initial value of the underlying asset is V, then at the end of the first time period, it will either become Vu up or Vd down, that is, the value of the first node may be Vu or Vd; similarly, at On the basis of the first node, the change in asset value will be one of two possible outcomes. Specifically, if the first node is Vu, then when the second period ends, it will either become Vu2 upwards. , Or down to Vud; and if the first node is Vd, then when the second time period ends, it either becomes Vud up or down

The NPV method is also a common method for project evaluation. Its advantage is that the evaluation is quantified and convenient and feasible. However, compared with the real option method, the NPV method shows its shortcomings. The actual value of the project estimated by the real option method is the expanded NPV, or the NPV of the real option with flexibility, and the actual value of the project estimated by the NPV method is static value, which is not flexible Sexual net present value [, this value is generally lower than the value estimated by the real option method. The reason for this gap is related to the shortcomings of the NPV method.

So-called

The Significance of Applying Real Options Theory Method in Venture Capital

Venture capital is a high-risk investment. There is a high degree of information asymmetry in its operation. Whether a venture capitalist can dynamically and accurately assess the value of a venture-backedenterprise based on limited information and make corresponding investment decisions will directly affect the success or failure of venture capital operations.

Therefore, being able to apply appropriate evaluation methods and evaluation theories directly affects the success or failure of China's venture capital industry. In practice, many large investment banks have gradually adopted the real option theory evaluation method instead of the traditional evaluation method. It turns out that the real option theory method is a method that can accurately evaluate the value of entrepreneurial enterprises. Therefore, if China can use it better This kind of financial innovation tool into the practice of venture capital investment will surely promote the sound development of China's venture capital industry.

Real option theory method and value evaluation of entrepreneurial enterprises

Start-up enterprises are mostly high-tech companies, which have the characteristics of fast update of knowledge, short product life cycle, high frequency of technological innovation, and large uncertainty of the external environment of the enterprise. Therefore, the biggest characteristics of venture capital are high risk and multi-stage continuous investment (sequential investment).

The real option theory better reflects the characteristics of risk, uncertainty and continuity of project investment, so the evaluation of enterprise value is closer to the true value of the enterprise. Of course, the above explanation only reflects a basic framework or basic idea of the real option theory for the evaluation of entrepreneurial enterprises. In specific applications, due to the actual situation of venture capital investment, the use of unreal real option models and evaluation methods is only available. Only in this way can we really help the development of venture capital in China.

China needs to pay attention to two problems when using the real option method. First of all, the evaluation method of real options is a quantitative analysis method. In actual economic activities, the value of an enterprise is often difficult to reflect the value evaluated by an evaluation method. Therefore, in actual operation, we can use quantitative The method (real option method) combined with qualitative analysis method can reflect the basic quality and elastic value of the enterprise. Secondly, there are many types of real options, and the theoretical and practical circles have not yet formed a universal model applicable. This requires us to choose a real option model that is suitable for evaluation in the application. For example, as mentioned above, for the characteristics of multi-stage venture capital investment, a simple real option model cannot be adopted. In general, the application of real option theory and evaluation methods should be based on specific enterprises and specific situations to determine the appropriate specific method, so that the theoretical method can truly play its role in China's economic activities.

Real option theory has not been introduced into China for a long time, and its application is relatively small. For real estate investment decision-making, there are many uncertain factors, and there are many difficulties in applying real option theory. But on the basis of retaining the reasonable connotation of traditional investment decision analysis, taking full advantage of real option theory to consider investment uncertainty and flexibility, and using its pricing method to improve traditional investment decision methods, it provides new ideas for accurately assessing project value. Enriched investment decision theory, improved the scientific nature of investment decisions, and facilitated the rational operation of real estate investment.