There are several other methods of calculating the value of a new firm, by considering it as a project or a series of decisions. These methods include decision tree analysis, scenario analysis and real options pricing techniques. While the examination of these new methods and their possible applications is interesting and well may lead to new, more accurate techniques for arriving at a correct valuation, the are not commonly used in practice by analysts (Demirakos, Strong, & Walker, 2004). Of these methods, real options pricing stands out.
Real options pricing resolves some critiques of discounted cash flow valuations in the valuation literature. The static nature of the required rate of return in discounted cash flow valuation ignores the value of the flexibility of management in responding to changing situations and new information (Busby & Pitts, 1997). The basis of real options theory is the application of financial options pricing theories to investments in real capital and assets, in order to give value to timing and strategic options presented during a firm’s project development (Pinches, 1998). Real options analysis and the application of real options theory in valuation has been developing as an academically accepted method to account for that flexibility and the value of the options to abandon, defer, expand, contract or switch to a different project (Reyck, Degaeve, & Vandenborre, 2006).
Real options pricing can be applied to entrepreneurial ventures just as it is applied to projects and development processes in larger corporate settings. Fundamentally, the process of pricing options involves creating a portfolio of a risk free asset and a number of call options that will offer the same return as the underlying asset on which the option is based (Ross, Westerfield & Jordan, 2008, p. 439). In applying the options pricing model to firm valuation, the initial investment required is considered a call option on continuing operations (Gompers, 1998). Using this technique, a firm’s valuation, using discounted cash flows, can be augmented by the value of future options, rendering the firm’s valuation increasingly reflective of its operating reality (Reyck, Degraeve, & Vandenborre, 2006). Discounted cash flow valuation inherently assumes that the project will continue as projected once it is set in motion. In fact firms have the option to alter their strategies or adapt to new approach. Giving value to these future options generally improves understanding the value of a firm.
There are some difficulties in applying the financial asset options pricing model. These are due to: the greater number of variables associated with real options; the fact that most asset ownership is non-exclusive; and time and value effects of competition in the market (Pinches, 1998). Additionally, considering real options is not always desirable because it has a tendency to reduce the level of commitment to a planned outcome or event (Busby & Pitts, 1997). While the application of real options valuation may be difficult, it is important to keep in mind the option’s effect on firm value. Academics believe that capital budget decision making will significantly employ real options pricing theory in the near future (Gompers, 1998).