# Real Options Explained: Definition, Valuation, and Examples

![Real Option: The right, but not the obligation, for a firm's management to undertake certain business opportunities or investments.](https://www.investopedia.com/thmb/RQKv5QMYgZo6w3yxMazmyIcWOXE=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Realoption_final-b85b4533830d40118566a3c352b04ab5.png)

*— Investopedia / Michela Buttignol*

## What Is a Real Option?

A real option allows company managers to make strategic business decisions involving tangible assets, like machinery or land. This concept involves choices, such as expanding or abandoning projects, based on fluctuating economic conditions. Calculating the value of real options helps firms determine potential opportunities or risks in their strategic planning. Unlike financial options, which are traded as securities, real options are embedded within business operations, offering a flexible approach to investment and project management.

### Key Takeaways

*   Real options provide managers the right, but not the obligation, to make business decisions involving tangible assets.  
    
*   They differ from financial options as they involve real, physical assets and do not trade on exchanges.  
    
*   Valuation of real options is complex and subjective, often similar to financial options, factoring in potential benefits and risks.  
    
*   Real options are most beneficial in volatile environments where flexibility is crucial for project management decisions.  
    
*   Common scenarios for real options include choices to expand, defer, abandon, or change the scale of projects based on market conditions.

## How Real Options Impact Business Decisions

Real options are choices that a company’s management gives itself the option to make, in order to expand, change, or curtail projects based on changing economic, technological, or market conditions. Real options impact the valuation of investments, but typical methods often overlook their potential benefits.

Using real options value (ROV) analysis, managers can estimate the [opportunity cost](https://www.investopedia.com/terms/o/opportunitycost.asp) of continuing or abandoning a project and make better decisions accordingly.

It is important to note that real options do not refer to a derivative financial instrument, such as call and put options contracts, which give the holder the right to buy or sell an underlying asset, respectively. Instead, real options are opportunities that a business may or may not take advantage of or realize.

A new manufacturing facility could give a company options like launching new products, merging operations, or adjusting to market changes. When deciding whether to invest in the new facility, the company should consider the real option value that the facility provides. Other examples of real options include possibilities for [mergers and acquisitions (M&A)](https://www.investopedia.com/terms/m/mergersandacquisitions.asp) or [joint ventures](https://www.investopedia.com/terms/j/jointventure.asp).

## Methods for Valuing Real Options

Determining the exact value of real options is often challenging. For instance, real option value may be realized from a company undertaking socially responsible projects, such as building a community center. By doing so, the company may realize a benefit that makes it easier to obtain necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits.

In dealing with such real options, a company’s management team factors the potential for real option value into the decision-making process, even though the value is necessarily somewhat vague and uncertain. Of course, the key difference between real options and derivatives contracts is that the latter often trades on an exchange and has a numerical value in terms of its price or [premium](https://www.investopedia.com/terms/o/option-premium.asp). Real options, on the other hand, are far more subjective. Management can use experience and financial valuations to assess a project's value and risk.

Still, valuation techniques for real options often appear similar to the pricing of financial options contracts, where the spot price or the current market price refers to the current [net present value (NPV)](https://www.investopedia.com/terms/n/npv.asp) of a project. The net present value is the expected cash flow from a project, adjusted by a rate that could be earned elsewhere. The alternative rate or [discount rate](https://www.investopedia.com/terms/d/discountrate.asp) might be the rate of a U.S. Treasury bond, for example. If Treasuries pay 3%, then the project or the cash flows must yield a return of more than 3%; otherwise, it wouldn’t be worth pursuing.

Some valuation models use terminology from [derivatives](https://www.investopedia.com/terms/d/derivative.asp) markets wherein the [strike price](https://www.investopedia.com/terms/s/strikeprice.asp) corresponds to non-recoverable costs involved with the project. In the derivatives world, the strike would be the price at which the options contract converts into the underlying security that it is based on.

Similarly, the [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp) of an options contract could be substituted with the time frame within which the business decision should be made. Options contracts also have a [volatility](https://www.investopedia.com/articles/investing-strategy/071616/implied-vs-historical-volatility-main-differences.asp) component, which measures the level of risk in an investment. The higher the [risk](https://www.investopedia.com/terms/r/risk.asp), the more expensive the option. Real options must also consider the risk involved, and it too could be assigned a value similar to volatility.

Other methods of valuing real options include [Monte Carlo simulations](https://www.investopedia.com/terms/m/montecarlosimulation.asp), which use mathematical calculations to assign probabilities to various outcomes given certain variables and risks.

## Important Considerations in Real Options

### Heuristic Reasoning

Real options analysis is still often considered to be a [heuristic](https://www.investopedia.com/terms/h/heuristics.asp)—a rule of thumb, allowing for flexibility and quick decision making in a complex, ever-changing environment—based on sound financial criteria. The real options heuristic is simply the recognition of the value embodied in the flexibility of choosing among alternatives although their objective values cannot be mathematically determined with any degree of certainty.

Even if a quantitative model is employed to value a real option, the choice of the model itself is based on judgment and often a trial-and-error approach since the choices available can vary across firms and project managers.

Having options affords the freedom to make optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management choices to make investments can give companies real options to take additional actions in the future, based on existing market conditions.

In short, real options are about companies making decisions and choices that grant them the greatest amount of flexibility and potential benefit regarding possible future decisions or choices.

### Choices That Fall Under Real Options

The choices that corporate managers face that typically fall under real options analysis are under three categories of [project management](https://www.investopedia.com/terms/p/project-management.asp).

1.  The first group is options relating to the size of a project. Depending on the ROV analysis, options may exist to expand, contract, or expand and contract the project over time, given various contingencies.
2.  The second group relates to the lifetime of a project—to initiate one, delay starting one, abandon an existing one, or plan the sequencing of the project’s steps.
3.  The third group of real options involves the project’s operations: the process flexibility, product mix, and operating scale, among others.

Real options are most appropriate when the economic environment and market conditions relating to a particular project are highly volatile yet flexible. Stable or rigid environments will not benefit much from ROV and should use more traditional corporate finance techniques instead. Similarly, ROV is applicable only when a firm’s corporate strategy lends itself to flexibility, has sufficient information flow, and has sufficient funds to cover potential downside risks associated with real options.

## Real-World Applications of Real Options

McDonald’s Corp. [(MCD)](https://www.investopedia.com/markets/quote?tvwidgetsymbol=mcd) has restaurants in more than 100 countries. Let’s say the company’s executives are mulling the decision to open additional restaurants in Russia. The expansion would fall under the category of real option to expand. The investment or capital outlay would need to be calculated, including the cost of the physical buildings, land, staff, and equipment.

However, McDonald’s executives would need to decide if the revenue earned from the new restaurants will be enough to counter any potential country and political risk, which is difficult to value.

The same scenario could also produce a real option to wait or defer opening any restaurants until a particular political situation resolves itself. Perhaps there’s an upcoming election, and the result could impact the stability of the country or the regulatory environment.

## How Do Real Options Work for a Company?

With real options, a business’s management gives itself the option to expand, change, or curtail projects based on changing economic, market, or technological conditions. Factoring in real options affects the valuation of potential investments; however, commonly used valuations fail to account for the potential benefits that real options provide.

## How Are Real Options Valued?

In dealing with real options, a company’s management team factors the potential for real option value into decision making, although the value is somewhat vague and uncertain. Valuation techniques for real options often appear similar to pricing financial options contracts, where the spot price or current market price refers to the current net present value (NPV) of a project.

## When Are Real Options Most Appropriate?

Real options are most appropriate when the economic environment and market conditions relating to a particular project are highly volatile yet flexible. Stable or rigid environments will not benefit much from real options value (ROV) analysis and should use more traditional corporate finance techniques instead.

## The Bottom Line

Real options empower a company's management by offering the right, without an obligation, to pursue or halt business projects or investments based on evolving economic, market, or technological conditions. They involve tangible assets rather than financial instruments, allowing companies to adapt strategically. This flexibility is valuable, providing the opportunity to make informed decisions around expanding, deferring, or abandoning projects in response to uncertain environments.