Real Option Valuation of Early Stage Technology

1. Michael Brand
Real Option Valuation of
Technology
Application of Precision Tree
Palisade Risk Conference
2011
© 2011Captum Capital Limited

2. Valuation of Real Options
§ What are Real Options?
§ How are they valued?
§ Precision Tree models
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3. Amsterdam – in year 1637
Bubble Tulips by Nancy Ethiel
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4. The Viceroy Tulip
Source: Wikipedia
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5. Tulip prices escalated x 20
Source: Wikipedia
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6. Future Value of a Tulip Bulb
§ In February 1637, a Viceroy Tulip bulb
was worth 3,000fl.
§ You are offered an option to acquire 1000
bulbs in six months time at 3,000fl per bulb
§ What would you pay to acquire this
option?
Futures markets flourished in Amsterdam in 1637
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7. Tulip prices crashed
Source: Wikipedia
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8. Future Options are Risky
Newton lost £20,000 of his own money in the South Sea Bubble of 1720
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9. Gold Mine Option
§ You own a gold mine
§ Geological survey estimates it contains
1 metric tonne of gold
§ What is the value of the mine?
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10. Value of Gold Mine
§ Its value depends on the price of gold
§ Risk
§ You can start or stop mining depending on
the price of gold
§ Flexibility in outcome
This is a classic Real Option
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11. Historic Gold Price Trends
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12. Real Options
§ Risk or Uncertainty in the…outcome
§ Non­linearity: flexibility to react in different
ways…so that a new set of outcomes is
achieved
Source: Michael Rees, Financial Modelling in Practice (2008)
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13. Technology Development
Commercial
Success Development
R&D
Project
Fund
Failure
Fund Option Exercise
Price
Option Price
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14. Risk Adjusted NPV
P C
rNPV = å t t t
( + R
1 )
rNPV depends on 3 factors:
•Probability, P
•Cash Flow, C
•Discount Rate, R
Most commonly used method for valuing technology
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15. Technology Project Value
Year 0 1 2 3 4
Cash Flow ­100 0 ­1255 0 15735
P 1 0.5 0.5x0.9
PV ­100 ­1000 10000
Cash Flow in £000s
Discount Rate R = 12%
rNPV = ­100 + 0.5 x ­1000 + 0.45 x 10000 = £3,900,000
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16. Decision Tree Value
Cash Flow in £000s
Discount Rate R = 12%
All Cash Flows discounted to PV
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17. Real Option Valuation
§ Key variables
§ Underlying Asset Value – Enterprise Value
§ Exercise Price
§ Term to Exercise
§ Volatility of Underlying Asset
§ Discount Rate
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18. RO Valuation Methods
§ Black Scholes Option­Pricing Model*
§ Binomial Model*
§ Monte Carlo Simulation
§ Decision Tree
* Developed for financial option valuation
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19. Black Scholes Equation
Present Value of a Call Option:
- r t
PV = PN ( 1 ) - EXe f N ( 2 )
d d
where:
2
N(d) = normal probability function
log( P / EX ) + r t + s t / 2
f
d =
1
EX = exercise price
s t
t = time to exercise
log( P / EX ) + r t - s 2 t / 2
t
d 2 = P = price of security
s t _
( P - P 2
)
σ = variance on return =
N - 1
r = risk free rate
f
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20. Binomial Model
Enterprise Value each year goes:
EV = S x u
u up by a factor u, or
p down by a factor d
EV
s
u = exp( t )
1
1 ­ p d =
u
EV = S x d
d ( + r ) - d
1 f
p =
t
u - d
σ = sales volatility, between 20%
and 40% for R&D projects
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21. Monte Carlo Simulation
§ @Risk Model for rNPV
§ Binomial Functions model decision nodes
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22. @Risk Model
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23. @Risk Model Output
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24. Abandonment Options
R&D Project rNPV = 3900
£000s
­1000
­100
rNPV = ­600
rNPV = ­100
Mean rNPV = £635k Max rNPV = £3900k
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25. Strategic Decision Options
§ Defer Investment
§ Default
§ Expand
§ Contract
§ Shut Down and Restart
§ Abandon
Lenos Trigeorgis, Real Options (1996)
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26. Multiple Milestones
Scale up CT1 CT2 FDA
4.5
Medical Device Development Project
0.9
0
0.6 ­ 0.3
­ 0.5
0.4 ­ 0.2
­1.5
0.7 ­0.2
Cash Flow £m
­ 0.1
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27. Medical Device Decision Tree
27

28. Clinical Trial 1
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29. Exercise Options
1. Invest in further R&D
2. Rerun test
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30. Summary
§ Decision Trees are a viable approach to
Real Option Valuation:
§ Simple to construct using Precision Tree
§ Flexible – changes of strategy
§ Transparent – ease of communication
§ Credible ­ not a “Black Box”
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31. About Captum…
§ Formed in 2004
§ Transatlantic presence
§ Life science sector consulting:
§ Business development, valuation, partnering
§ MasterClasses:
§ Valuation Masterclass attended by over 500
executives in UK and Europe
§ Internet virtual communities
§ Sensor100
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32. Coming Events
§ MasterClass: Company Valuation
th
London, 25 May 2011
§ Workshop: Evaluating Technology
LES International Conference
th
London, 8 June 2011
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33. Captum Growth Series
Valuing Technology
nd
2 edition
To be published
May 2011
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34. Contact
Captum Capital Limited
Cumberland House
35 Park Row
Michael Brand Nottingham NG1 6EE
e: mjb@captum.com United Kingdom
t: +44 (0) 115 988 6154
m: +44 (0) 7980 257 241 www.captum.com
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