Discounted cash flow valuation and real options

The discounted cash flow (DCF) method is ubiquitous in valuation of businesses and business assets. The net present value analysis is the extension of the standard DCF technique in valuing capital investment projects. Such projects cover business valuation in acquisition scenarios as well as purchases of equipment and machinery.

Yet with all the popularity of DCF analysis, the methodology does have a weakness: it does not account for the flexibility in capital investment projects. If you were ever involved in a large scale capital investment projection, you might have noticed that the company can change its decision in real time depending on the situation.

Just some examples that often happen in the real world:

You may be considering upgrading some equipment across the entire company. Before committing to such a major outlay though, you might want to replace one or two machines first and see how well they perform. If the performance meets your expectations, you could choose to proceed with the enterprise-wide upgrade. If the early results prove disappointing, you might reconsider your replacement plan.

From the investment perspective, this works like a call option. You reserve the right, under no obligation, to buy some assets on or before a future date at a predetermined price.

Here is a different example. Your company is considering a project that could result in some future cash flows. There is a degree of uncertainty as to whether this income expectation will pan out. If you use the discounted cash flow valuation, your analysis is going to miss this downside. To deal with the uncertainty, you could opt to drop the project early if things don’t look as expected.

This strategy works like a put option. You reserve the right to abandon the project. You reduce the scale of the project investment early should things not work out.

In capital investment valuation, these strategies are known as real options. They work to extend the power of the discounted cash flow valuation. In a sense, your project becomes more valuable because you allow for more positive outcomes. The discounted cash flow analysis assumes that you are committed to investment without regard for the options of bailing out early if things don’t work out.

If real options are part of your business strategy, your DCF analysis could underestimate the value of the project.

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