What is Real Options Analysis?

Real options analysis (ROA) is a term in finance that primarily applies to an option to craft, dump, inflate or minimize a capital investment. The process of ROA can assist in leaving investment options open, thereby enabling the investor to explore other potentially riskier possibilities. This can be done via ROA without the investor having to commit long-term to these speculations. It makes analysis possible while finding investment stopping points.

The methods and techniques involved in real options analysis can be stretched from corporate finance applications to general decision-making under uncertainty. Research and development managers are apt to use ROA in order to figure out the best investment plan for their company. An example of a non-corporate use for ROA could be the decision to work after graduating from high school or to enroll in a college degree program. ROA forces the individual or group to be unambiguous about the suppositions in their projections.

Researchers in the fields of business and financial strategy have suggested that a number of corporate decisions can best be examined and dissected through the process of real options analysis. These decisions often include the termination of shared ventures, the administration and control of several multinational manufacturing associations and investments in the venture capital arena. One common thread connecting these kinds of decisions is their inherent two-step progression. First, a relatively small investment is made that allows the investor to take part in the venture. Then, after gleaning more knowledge about the project, the investor will decide whether or not to increase the amount invested.

Many of the standard methods of capital budgeting are often contrasted with real options analysis. An example of this is in a process called net present value (NPV). NPV mainly considers only the most probable results and essentially ignores other more flexible options. Inherent to the NPV method is that it takes for granted that management will be passive once a commitment is made on their investment. ROV instead presumes just the opposite: that management will be an active participant in their investment in regards to changing and modifying the project.

Professor Stewart Myers of the Massachusetts Institute of Technology’s Sloan School of Management in the US is given credit for inventing the term "real option" in 1977. Since that time, real options analysis has changed to reflect trends in the marketplace. The basic goal of ROA plans has remained that for all intents and purposes, it attempts to make projections about the future.