Real Options: Another Way To Value Internet Initiatives.

• Author: LATIMORE, DAN
• Position: Brief Article

Anyone who has tried to measure the value of an Internet investment has discovered the difficulty of presenting a compelling business case using standard techniques like net present value (NPV) or return on investment (ROI). Projected cash flows seem meager in comparison to the investment required, or the discount rate chosen to compensate for the risk is so high, it renders the NPV unpalatable. Analysts often resort to instinctive appeals of "synergy" or "strategic importance" to compensate for the valuation shortfall, Indeed, many executives instinctively know Internet initiatives have some sort of value that discounted cash flow analysis (DCF) fails to capture. The market value Wall Street ascribes to many dot-coms cannot be derived using DCF, yet billion-dollar companies without a profitable quarter are commonplace. What justification can there be for this apparent irrationality?

The root of the problem is that static valuation methods tend to undervalue investments made under uncertainty. For several years, the oil and gas industry and pharmaceutical companies, businesses characterized by large capital investments with extremely volatile payoffs, have been using "real options" to help them quantify the risks and potential rewards associated with making investments in risky environments.

These characteristics also describe Internet initiatives. Outcomes are extremely uncertain, investments are high and the risk of losing everything is real. Yet the potential upside is huge. Real options recognize that today's investments in Internet projects give investors the choice of pursuing further investments later, if conditions appear favorable, or abandoning the project if the environment has deteriorated. The capital investment made today provides future flexibility that can and must be valued, but is often missed by traditional DCF or ROI measures. Borrowing from both finance and strategy, real options can provide a way to analyze the value of investing in Internet initiatives. This article isn't meant to be comprehensive, but to provide an introduction to the use of real options and how they can benefit companies pursuing Internet initiatives.

Like Financial Options

Real options borrow heavily from the world of financial theory. A call option gives the buyer the right, but not the obligation, to buy a security at a specified price in the future. The buyer of the call option is taking an optimistic view of the security underlying the call option. Similarly, a capital investment today that gives the investor the future right, but not the obligation, to make a further investment is a real option. Many factors influence the value of the option. For example, as the value of the stock (or the present value of the expected cash flows) increases, so does the value of the call option. In fact, real options are directly...