The market values a growth company largely by estimating the prospects of its portfolio of growth projects. These projects — research and development, investment in new capacity, geographical expansion, and other initiatives — are seldom simple one time decisions; in most cases, a company’s investments are multistaged, and at each step the company may push ahead or abandon the investment after gaining new information. These projects are thus a series of decision or “real” options, in strategic planning and investment analysis, in which managers have the right but not the obligation to invest or follow certain paths in strategic development.
Real option theory is a modeling methodology by which one attempts to plan ahead by identifying the right to make current and future decisions, where each decision is interdependent with other decisions and where each has probable opportunity cost and probable payoff attributable to it, which can then be used to develop risk weighted outcomes or values, given current and future information.
Real option modeling is a useful decision tree methodology by which one can, among other things, develop strategic plans and values by modeling probabilities and their respective payoffs. Real option modeling is often used in strategic and business planning, new or early stage company planning, entrepreneurial opportunities, and legal decisions such as determining the probable cost and probable outcomes in one’s decision to litigate or settle a cause of action. Real option modeling is a useful tool which can also be integrated into business valuation by identifying the likely options and decisions a business faces in the near future and the respective probable payoffs which each decision has, which directly affects cash flows and values.