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

PITFALLS AND PRATFALLS IN REAL OPTIONS VALUATION

In the previous sections, we examined the many attractions of using real options valuation for corporations and especially financial analysts. One might get the impression that real options valuation is easy to do or that it is an infallible financial tool. Indeed, a reading of the literature on the subject reveals a notable absence of criticisms and limitations. But, in fact, real options valuation suffers from numerous criticisms and limitations and can be particularly difficult to implement. Some of these criticisms are relatively minor, but some are quite important.34 In this section, we attempt to address some of the concerns associated with real options valuation, noting weaknesses along with strengths, identifying criticisms that are valid and those that are not, and showing a more balanced view than is generally found elsewhere. We stress that our goal in this chapter is neither to glorify real options valuation nor to tear it down. Our goal is to inform. To that end, we argue that real options valuation is a powerful tool, but as with all powerful tools, it must be used properly with a recognition of its limitations and weaknesses.

We also would like to emphasize that our treatment of these issues is at a basic level. Our objective is a modest one—to apprise the reader of issues, concerns, and caveats. We do not have the space to devote to providing a detailed explanation or resolution of these issues. Indeed, many of the ...