Real options is the extension of financial option theory to options on real (nonfinancial) assets. In contrast to the valuation of financial options where decision-making it is a matter of shopping for the best deal on a specified contract the valuation of a real option requires that it be identified and specified..
While the Present Value Calculations and standard Discounted Cash Flow techniques are needed as check on strategic analysis, they can not estimate he option value attached to a new/profitable line of business.
According to Myers
"Strategic planning needs finance. Present value calculations are needed as a check on strategic analysis and vice versa. However, standard discounted cashflow techniques will tend to understate the option value attached to growing profitable lines of business. Corporate finance theory requires extension to deal with real options."
Stewart C. Myers, Sloan School of Management, MIT (1984)
So does the market price real options ? Consider this ..
Lucent. - If you used a traditional analysis based on projections of cashflow from current products, Lucent would be priced at just over $4 per share. Since its spinoff from AT&T, Lucent has been trading far above that amount, often in the range of $70 per share. The difference is the capitalization by the financial markets of Lucent's growth options
Amazon.com. - Company went public before becoming profitable and announced in its IPO prospectus that it would not be profitable in the near future. Amazon.com is also a growth option play. A large part of the company's value is its strategy to make strategic investments today that create options - opportunities to possibly make further investments in the future. Enhancing Amazon's value is Wall Street's perception that the company has the managerial abilities to execute these options.
Cable industry (The case for tomorrow) - Laura Martin of Credit Suisse First Boston has used the real options approach to value cable plant.
Real estate - Emphirical evidence suggests that real estate prices reflect development options and research papers such as Quigg (1993) prove it.
The real options approach has and can thus be been applied to water infrastructure, film , industry, technology sectors like telecom, R&D sectors like Pharma, Biotechnology and capacity critical sectors like Power.
Get the real options FAQ here while I wait for Proff Mohanty to shred the case threadbare with his analysis tomorrow (or today its past 5:00 am already;)