Valuing technology investments: use real options thinking but forget real options valuation

Abstract

Real options valuation (ROV) has recently been proposed as a promising solution to the deficiencies of traditional valuation methods when facing risky technology investments or ventures. Indeed ‘real option thinking’ - the managerial flexibility to capitalise on opportunities when they arise and/or to minimise the impact of threats - is precisely what is needed when faced with the uncertain future of technology investments. Notwithstanding this we argue that traditional decision tree analysis methods are preferred to ROV techniques when valuing technology investments that contain ‘real options’. Our reasoning is twofold. First, ROV techniques provide a sophisticated treatment of market risks, but do not deal with firm-specific risks. However, the elevated risk facing technology ventures is predominantly firm-specific risk, and these ventures face only about average levels of market risk. Second, ROV has a severe practical limitation in the context of new technology ventures. Normally, the favoured approach when using ROV to value investments is to use the ‘market asset disclaimer’ assumption. The starting point is to value the venture/project in the absence of the ‘real options’ using traditional discounted cash flow techniques (to establish the value of the underlying asset). ROV analysis then adjusts this valuation to take account of the real options. But the first step makes no sense for technology ventures because these ‘real options’ are an integral part of the venture.