Real Options Analysis: Where Are the Emperor's Clothes?

TLDR

Real options analysis has moved from a niche finance topic to mainstream business schools and industry, yet its various approaches differ markedly in assumptions, techniques, and outcomes, demanding careful selection. The article critically reviews five established real options approaches to guide practitioners. It examines the classic, revised classic, subjective, MAD, and integrated approaches, detailing their assumptions, mechanics, application ranges, and results on a natural gas field case. The revised classic approach is best for cases dominated by market or private risk with limited resources, while the integrated approach suits mixed market and technological risks requiring accuracy and a management roadmap.

Abstract

Once a topic of interest only to finance specialists, real options analysis now receives active, mainstream attention in business schools and industry. This article provides practitioners with a critical review of five well-established real options approaches that are extensively documented in the academic and professional literature. These approaches include the "classic approach" and "revised classic approach" (as proposed by Martha Amram and Nalin Kulatilaka), the "subjective approach" (as proposed by Tim Luehrman), the "MAD Approach" (as proposed by Tom Copeland and Vladimir Antikarov), and the "integrated approach" (as proposed by James Smith and Robert Nau). The article discusses the assumptions, mechanics, and potential range of applications of each approach, along with the results when applied to a simple case involving development of a natural gas field. While the approaches share a focus on investment flexibility and shareholder value, they rely on fundamentally different assumptions, use significantly different techniques, and can produce dramatically different results. Consequently, a great deal of thought must go into selecting and applying them in practice. The revised classic approach appears to be best suited to cases dominated either by "market" risk or "private" risk alone, and where approximate results are acceptable and resources are limited. The integrated approach is best suited to cases with a mix of market and technological risks, and where accuracy and a management roadmap are critical.