specifiedlevel.Therearemanyassetsthatgenerallyarenot
viewed as options but still share option characteristics. A
patentcanbeanalyzedasacalloptiononaproduct,withthe
investmentoutlayneededtogettheprojectgoingconsidered
thestrikepriceandthepatentlifebecomingthelifeofthe
option.Anundevelopedoilreserveorgoldmineprovidesits
ownerwithacalloptiontodevelopthereserveormine,ifoil
or gold prices increase.
TheessenceoftherealoptionsargumentisthatDCFmodels
understatethevalueofassetswithoptioncharacteristics.The
understatement occurs because DCF models value assets
based on a set of expected cash flows and do not fully
considerthepossibility thatfirms canlearnfrom real-time
developmentsandrespondtothatlearning.Forexample,an
oilcompanycanobservewhattheoilpriceiseachyearand
adjust its development of new reserves and production in
existing reserves accordingly rather than be locked into a
fixedproduction schedule. As a result,there shouldbe an
optionpremiumaddedontotheDCFvalueoftheoilreserves.
Itisthispremiumonvaluethatmakesrealoptionssoalluring
and so potentially dangerous.
Applicability and Limitations
Using option pricing models in valuation does have its
advantages.First,therearesomeassetsthatcannotbevalued
with conventional valuation models because their value
derivesalmostentirelyfromtheiroptioncharacteristics.For
example,abiotechnologyfirmwithasinglepromisingpatent
fora blockbustercancerdrugwending itswaythrough the
Food and Drug Administration (FDA) approval process
cannot be easily valued using DCF or relative valuation