No, surprisingly. I had to look it up.

I've dealt with stochastic models that treated corporate investment decisions as real options (American, not European) based on the work of Dixit (Princeton) & Pindyck (MIT Sloan), but it was extremely academic, mathematical, and unrelatable to the real world.

As one Amazon reviewer for their key book on the subject notes: "This is probably the most useless book on real options which I own. The book is extremely difficult to follow and uses academic mathematical notation which is difficult for practitioners to follow. In addition, the authors have largely ignored both the underlying business operations which create real options and the existing operations literature on project management, operations research, petroleum engineering, manufacturing systems engineering, etc. which provide many of the tools necessary for practical evaluation of real options. The bottom line is don't waste your money on this book."

We used academic journal articles rather than books, but I would have to agree with the gist of the sentiment there.

Anyway, I looked up the NPVq stuff, and it looks much more practical and useful. I probably would have enjoyed a course that had it. DCF works for assessing individual business projects against a benchmark IRR, but classical NPV does a better job at prioritizing net value creation. Classical NPV clarifies thinking on net value creation, but NPVq reflects the nuances of timing factors involved with projects that businesses often shelve or re-embrace.

European options would seem to cut out a lot of the real-world nuance on timing, but it's probably a good approximation, and thus a good idea to make that simplification anyway.

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Posted by RedStickBR

Member since Sep 2009

14577 posts

Posted on 1/6/18 at 6:30 am to Doc Fenton

I'm late chiming in, but had been meaning to circle back. lynx, I'm not familiar with NPVq but would be curious to review anything you might have on it.

Re: IRR vs NPV, I view them like a flathead and a Phillips - similar in what they are trying to accomplish (aid in an investment decision) but nonetheless different in some key ways that give them different uses for different scenarios.

In the project finance / corporate finance / what I'd call "corporate PE / VC" work that I do, I prefer IRR because it requires one fewer variable (don't have to estimate a discount rate), and it's how PE tends to track our business. For instance, if our business is currently producing a 9.0% levered IRR on a PE owner's original investment, I want new projects to be in excess of that in order to be accretive to their yield. There's some nuance behind why that is so important in my little niche of the world, but IRR definitely reigns supreme. Of course, your analysis would typically include a discussion of NPVs as well with sensitivity provided around the discount rate. I tend not to use a corporate WACC or ROE as my discount rate, because I like the analytical rigor that goes into supplying a different discount rate for each project based on its own individual risk factors.

We should have one mammoth thread on valuation. Having worked in a number of different areas of finance now (both institutional and corporate), it's interesting to think back on and discuss how your views are refined as your knowledge broadens.

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