An Analysis and Comparison of Real Option Approaches for Project Valuation under Uncertainty

Abstract

Several different real option valuation approaches appear in the literature to address valuation problems under uncertainty. This diversity, however, has created a confusion regarding their applications across different types of settings. We propose a real option valuation taxonomy to clarify these issues by analyzing and comparing the limitations, advantages and correct application conditions of four selected real option approaches. The analysis and comparison is based on three criteria: the nature of the capital market, the classification of project-specific uncertainty, and the source of the data. Through systematic comparison, we specify the appropriate choice of valuation framework and the reasons that drive this choice. We also give some simple numerical examples to illustrate these points. Understanding which approaches should be used to value which projects and how to apply an approach appropriately can effectively enhance the value of the investment and improve strategic decision-making.