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In the time of the Internet frenzy, logic concerning how companies should be valued went out the window. The so called "new economy" no longer had to rely on traditional valuation techniques. Instead valuations were based on the number of "eyeballs" viewing a web site; capacity of the system; market potential; capacity or capital expenditures. None of these reflect the valuation, although they may be incomplete proxies for some component of value. These valuation techniques were used to value large, long-term fixed and sunk cost investments, as well as stock prices. The traditional discounted cash flow methodology (see next section) is not a state-of-the-art method, had it been used. New techniques, for example a real options valuation (ROV) methodology, may have prevented, or at least dampened, the overcapacity in the long distance sector that was built during the boom and remains in place today. Management, one would hope, should wish to avoid this error in the future.

Discounted cash flow analysis

What makes a company or project valuable is the future cash flows generated by the products and services it offers. The problem is to determine the cash flows and whether or not they suffice for maintaining the company over the long run.

The cash flow method of valuation is applicable for both investments in projects and stocks. Using this method, future cash flows are "discounted" to account for the fact that money today is more valuable than money tomorrow. That is, the cash flows have less value the further they are from the present. The intuition of this method is that the company should be able to earn on its investment an amount that is at least as great as it could earn in a risk-free asset, such as a government bond or a high grade certificate of deposit (CD). Instead of investing the money in the project, the firm could put the money in this safe investment, and earn the return on the safe investment without any risk. This traditional method to evaluate the investment is alternatively known as discounted cash flow (DCF), discounted net present value or present value. Since projects incur a certain amount of risk, the company should earn a risk premium. This is reflected in the discount rate and is known as the risk-adjusted discount rate.

While the theory and methodology have become more refined, as we will discuss, even this traditional method was generally ignored during the Internet/telecommunications boom of the late 1990s and early 2000s.

But the issue is more complicated than this because revenues and costs are difficult to predict. Particularly in the current telecommunications environment, uncertainty permeates the future. The traditional method of dealing with this uncertainty is to use a high discount rate--higher than the risk-free rate. And, indeed, this method works well in a mature, stable industry such as the old telecommunications sector. When competition did not exist and "Ma Bell" was the only provider of service, it could control the introduction of new technology, had modest and predictable increases in demand, and had a well-established history of its costs and revenues. Its stock behaved like bonds--reliable and stable. Primarily, its price varied with the interest rate.

With the breakup of the system in 1984, the introduction of ever increasing competition into the telecommunications sector, and a variety of intermodal competition, the future became a lot less predictable. The Telecommunications Act of 1996 and its implementation by the Federal Communications Commission (FCC) added yet another level of doubt about the future environment. The Congress and the FCC's flawed, shifting, and contradictory public policy did not improve the telecommunications environment. For the players in this market, everything changed. The local wireline carriers lost second lines and even customers to wireless services. The cable systems' cable modem offering ate into exchange carriers' DSL and other digital offerings. At the same time, these carriers were attempting to enter the long distance market. For the long distance carriers, in addition to the entry of the traditional regional wireline carriers into their markets, the wireless services were offering "anytime-anywhere" buckets of minutes at a single price for their service. This was a direct substitute for the offering of the LD carriers, and of course thwarted the wireline carriers' LD strategy. We could go on. The point is that the stable predictable world of telecommunications fell apart into one of chaos and uncertainty. An environment full of risks!

In this context, how does one calculate the value of a company or a particular project of a company? One thing that discount rates do not take into account is that management has control of the business and, over time, can expand a project, change the course of a project or shut it down, depending on market conditions. But how can this be accounted for in advance?

Real options analysis

Real options methodology is an answer. Instead of evaluating the stream of cash flows with present value analysis, ROV methodology attempts to account for the options embedded in a project and, using the tools to price financial options, values these options. The methodology replaces the risk-adjusted discount rate with a measurement of the uncertainty of the cash flows. The intuition is that if the options become valuable as market conditions reveal themselves, management can exercise its option and make the investment. If it does not, all that is lost is the cost of the option.

This is similar to how financial options work. A financial option is the right to buy (a call) or sell (a put) a stock, but not the obligation to do so, at a given price within a certain period of time. The price of the asset is known today. It has a history of a certain level of volatility, and the duration of the option is known, as is the exercise price. Given this information, the price of the option can be determined. Later, if the price of the asset is above the exercise price, the option is "in the money" and the option can be exercised for a gain. If not, the option is not exercised and the only loss is the price of the option. The option offers the potential of a large upside gain with a known and fixed limit on the downside loss. The asymmetry of the option, the protection from the downside risk with the possibility of a large upside gain, is what gives the option value. With ROV methodology, the idea is similar. The manager identifies options within a project and their exercise prices. If the future develops to be desirable, the option is exercised; if the future turns out to be bad, the option is not exercised. If the option is not exercised the only loss is the price of the option.

The real options analysis provides a means of capturing the flexibility of management to address uncertainties as they are resolved. Traditional cash flow analysis fails to account for management's flexibility and, moreover, it fails to integrate strategic planning. The flexibility that management has includes options to defer, abandon, shutdown/restart, expand, contract, and switch use (see Table 1). This methodology forces the firm to evaluate cash flows in greater detail, rather than the simple DCF view of valuation. The methodology is one that more closely matches the manner in which the firm operates. The use of real options methodology lets the firm modify its actions after market conditions have revealed themselves. For example, if demand fails to meet expectations, the firm may choose to delay investment rather than proceed along its original business case. The deferral option is the one that is generally illustrated and is treated as analogous to a call option. But real options analysis can be applied to evaluation of other management alternatives, for example shutdown and restart, time-to-build, or extending the life of a project or enterprise.

ROV methodologies can take the best features of DCF and decision tree analysis without their failings and can make a significant difference in the valuation. Real options expands the notion of the manager's flexibility and strategic reaction in skewing the results of the traditional DCF analysis which, as with financial options, allows for gains on the upside, and minimizes the downside potential; thus changing the valuation.

While the real options methodology has been recognized for nearly as long as the options pricing methods, it has not been used in either the telecommunications or the Internet sectors. Indeed, its value has only recently been publicized within the industry. It has barely entered the analyst's tool kit.

Yet real options methodology offers the possibility to integrate major analytical methods into a coherent framework that more closely approximates the dynamics of the firm's behavior without heroic assumptions regarding the dynamics of the environment.