Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

PREFACE

Real options are opportunities that are associated with investment projects characterized by a degree of flexibility. Real options involve choices: to invest or not, to terminate or continue an investment, or to defer or carry on with an investment, to name a few. Real options can have considerable value, not only to the companies possessing them but also to the analysts examining those companies. Uncovering the value of real options is a challenging task.

The purpose of this chapter is to bridge the gap between theory and practice in the application of option valuation methods to capital investment projects and to make real options valuation more accessible and comprehensible to practicing financial analysts. A large body of published literature exists on real options. Some of it is technically quite complex. Much of it oversimplifies the hidden complexities of real options valuation. In this chapter we bring to the analyst a consolidated and concise overview of the latest thinking from experts in real options, showing how these options are structured, how they should be valued, and how to apply the valuation models. In contrast to much of the published work on real options, we also provide a more critical analysis of the limitations of the models and the difficulties of using them.

The chapter is organized in the following manner. In the Introduction, we provide a general introduction to the topic of valuing companies and a specific introduction to the topic of valuation ...