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The Value of Real Options

Hard assets for hard times.
Marie Leone, CFO Magazine
May 1, 2002

As the appeal of asset-light balance sheets fades in the wake of accounting scams, many executives are heading for the cover of tangible assets. "Hard assets are really all that matters when valuing a company," argues Stephen Wright, an economics professor at the University of London and co-author of Valuing Wall Street. Wright and co-author Andrew Smithers make a case for measuring the profitability of tangible assets by asserting that the underlying value of a company's stock resides in its hard assets.

One way to measure the profitability of real assets, say some pundits, is to use real options. Interested in how it would play out? Keep an eye on the electric-power industry, which will act like a petri dish for testing real options theory in an unregulated marketplace.

As deregulation takes hold, power-station owners will run their plant assets only when the price of electricity makes it profitable, notes Paul Craven, executive vice president of Innogy America LLC in Chicago, a unit of U.K.-based energy company Innogy Holdings Plc. Craven also expects that the owners may mimic his U.K. parent company and use real options to make such market-based decisions. This is an enormous departure from operating in a regulated market in which these huge plants are often run continuously--sometimes regardless of price signals.

Why shy away from price signals? Regulated markets never put a premium on profitability, says Craven, adding that to follow the electricity price curve, assets will have to be run differently. Others agree. "Companies that are forced by the market to operate with higher profit margins also will be forced, in some cases, into the 'run-to-wreck' strategy that real options facilitates," says Jason Makansi, president of technology consulting firm Pearl Street Inc. and author of An Investor's Guide to the Electricity Economy.

The strategy, explains Craven, means that a plant owner can use real options to quantify technical risk--such as the wear and tear on a machine caused by quick starts and stops. Once the risk is quantified, owners can chance damaging a plant with a cold start-up, provided that the price of electricity sold covers maintenance and the profit margin. In other words, it will run only when it is "in the money," notes Craven.




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