CFO Magazine November 1999


IN PRACTICE: Valuing a New Venture with Real Options Analysis

By Nalin Kulatilaka

Portlandia Ale, a hypothetical start-up microbrewery, needs $4 million to begin product development and manufacturing and another $12 million in two years for its market launch. The entrepreneurs are optimistic, despite considerable uncertainty about the value of the market opportunity.

Portlandia shows potential investors a traditional business plan. Each quarter for the first two years, $500,000 would be spent. Then $12 million would be spent in the first quarter of the third year to launch the product line. The business plan assumes the launch will lead to a sustainable business with a market value of $22 million. (The value of the sustainable business is calculated as M/S x Portlandia's sales, where M/S is the average market value to sales ratio for mature microbrewery companies.)

But the investors are put off by a discounted cash-flow analysis. Even under two optimistic assumptions--business conditions will support the sales forecast in the plan, and the launch will be made--the net present value of Portlandia after two years is negative $230,000, as demonstrated in Table 1.

Table 1

Discounted cash-flow valuation of Portlandia Ale ($ millions)

  Today Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8


.50 .50 .50 .50 .50 .50 .50 12.00
Terminal value 22.00
PV of investment


.49 .49 .48 .48 .47 .46 .46 10.86
PV of terminal value 14.46
Net present value at 21% discount rate = $0.23


The entrepreneurs can sway the investors with a real options analysis. Portlandia's strategy is more complex, and its valuation is higher, than is recognized by the business plan. The plan fails to include the valuable option held by the start-up: Portlandia need not undertake the market launch. The launch will be made only if business conditions are strong enough to make the launch profitable. By investing in the early-stage development, Portlandia is in effect purchasing an option to launch the product. However, the costly launch will be done only if market conditions in two years' time make it sufficiently attractive.

The launching option held by Portlandia is analogous to a call option on a stock. Hence, we can use the well-known Black-Scholes formula to value Portlandia's launch option. The formula requires only five inputs to produce a single output, the current value of the option. Table 2 draws the parallel between the inputs needed in valuing a call option on a stock and the launch option. (A note of caution: not all real options can be valued so easily. Many corporate options are more complex and require tailored mathematical formulas.)

Table 2

Black-Scholes Inputs for Call Options and Launch Options

Call Option on a Stock Launch Option
S: Current stock price PV of benefits from launch (i.e., PV of terminal value = 14.46)
X: Strike price Launch cost ($12 million)
T: Time to expiration Time to launch (2 years)
r: Risk-free rate of interest Risk-free rate of interest
s: Volatility of the stock price Volatility of the value of the microbrewery (estimated from the market-traded prices of microbreweries = 40%)
D: Dividend yield Dividend yield of Portlandia until launch (clearly, equal to zero)


The current value of Portlandia's option to launch is $4.96 million. Its value comes from the upside potential. If two years from now business conditions are terrific, then there will be a very high payoff to the $12 million launch cost. If business conditions are poor, the product will not be launched and the $12 million won't be needed.

Portlandia now has a contingent strategy, one that depends on business conditions. Before the launch-decision date, Portlandia's total product-development cost will be $3.83 million in present value terms. The value of Portlandia with the launch option is $1.13 million ($4.96 million $3.83 million).

Next, let's more realistically characterize Portlandia's strategy by adding a set of additional options: the options to abandon the business at the end of each quarter. Suppose that at any time during the first two years, Portlandia could cease operations if business conditions soured to a level that the microbrewery could not see making the launch. The calculations at this point become a bit more complex, requiring specialized mathematical tools. The option to launch and the options to abandon are valued in an integrated manner, resulting in a $1.74 million valuation for Portlandia (see Table 3).

Table 3

Discounted cash-flow value versus real-options values

DCF Value Real options value Real options value
Commit to development and launch Commit to development but retain option to launch Retain options to commit development in stages and option to launch
-$230,000 $1.13 million $1.74 million

Where did the additional value come from? By assuming that Portlandia commits to completing the development process and going ahead with the launch, the DCF valuation ignored an important flexibility that the firm really had. In fact, a more realistic depiction of the investment process is one in which management will reassess business conditions at various intervals and make subsequent investments contingent on those reassessments. The real options analysis recognizes that these contingent decisions would in fact reduce the risk exposure of Portlandia Ale while retaining all the upside benefits.

Could we have used a decision tree analysis (DTA) to reach these conclusions? It appears at first glance that the real options method is very similar to DTA, which models possible future business outcomes and the reactions to those outcomes in a decision tree. However, the way in which future outcomes and their associated probabilities are modeled in DTA can be quite arbitrary and colored by analysts' opinions.

The subtle yet important difference in real options analysis is the market discipline it imposes. The analysis obtained its measure of the business risk from the prices of traded microbrewery stocks. The ability to replicate Portlandia's business risk with existing securities allowed us to value the business plan using real options.

- Nalin Kulatilaka is a professor of finance at Boston University School of Management. This article is based on Chapter 10 of Real Options: Managing Strategic Investment in an Uncertain World, by Martha Amram and Nalin Kulatilaka (Harvard Business School Press, 1999).