Session 22: The Option to Delay (Patents & Natural Resources)

Real Options: The Option to Delay

In this section, the speaker introduces the concept of using option pricing models in valuation and focuses on one specific type of option - the option to delay.

Understanding the Option to Delay

• The exclusive rights to an investment could still be valuable even if it's not viable today.

• This insight can be used to value non-viable patents, undeveloped reserves, and businesses that are impervious to traditional valuation models.

• The speaker explains how corporate finance teaches us to analyze a project by estimating expected cash flows, discounting them back to present value, and coming up with a net present value. If NPV is negative, we reject the project; if positive, we take it.

• However, there may be projects with negative NPV today but exclusive rights that could still be valuable in the future - this is where real options come into play.

Examples of Real Options: Patent Valuation

• Patents give you exclusive rights to commercialize something. You don't have an obligation to develop it into a product - that's your choice.

• Whether you develop a patent or not depends on two numbers: (1) cost of converting patent into a commercial product (let's call it A), and (2) value of cash flows from converting patent into a commercial product (let's call it B). If B > A, you'll develop the patent; otherwise, you'll sit on it and wait as long as you have exclusive rights.

• The payoff diagram for a patent looks like an out-of-the-money option. Strike price = cost of converting patent into commercial product; underlying asset value = present value of cash flows you would get if you develop the patent today or in the future.

• R&D expenses are the price you pay to get patents and options. Options are more valuable when there's more risk, so directing R&D to areas with more uncertainty can deliver more value.

The transcript is in English, so all headings and bullet points should be in English as well.

Valuing Patents and Real Options

In this section, the speaker explains how to value patents using real options. He discusses the inputs required for the option pricing model and provides an example of a valuation he did for a drug called Avonex.

Inputs Required for Option Pricing Model

• To value a patent using real options, you need to estimate the expected cash flows from developing the patent today by projecting future cash flows.

• There is no past price variance available when valuing a project or patent, so you can use Monte Carlo simulation or publicly traded companies' variances in firm value as shortcuts.

• The strike price should be relatively simple; it's the cost of converting the patent into a commercial product.

• The remaining inputs fall out of the option: life of the option is equal to remaining life of the pattern, and risk-free rate is over that life.

Example Valuation: Avonex Drug

• The company projected cash flows from developing Avonex immediately and estimated its present value at $3.422 billion.

• The cost estimated to convert Avonex into a commercial product was $2.875 billion.

• Using these numbers in traditional capital budgeting would give a net present value of $547 million, but since they haven't made an investment yet, it's still an option.

• By putting in 17 years as remaining life of the option and using publicly traded biotechnology companies' variance, he gets an option value of $907 million.

• The difference between net present value ($547 million) and option value ($907 million), which is $360 million, is the option premium.

Option to Delay

• The speaker explains how to use real options to value an oil company's undeveloped oil reserves.

• The choice of developing or leaving the reserves in the ground will be driven by the cost of delay.

Natural Resource Options

In this section, the speaker explains how to value an undeveloped oil reserve using option pricing theory.

Valuing an Undeveloped Oil Reserve

• If the value of an undeveloped oil reserve is greater than the cost of extracting it, you should develop and extract the oil. Otherwise, you should wait for prices to go up.

• The cost of extracting the oil becomes the strike price in option pricing theory, while the value of the oil in the ground becomes the underlying asset.

• To estimate inputs for valuing an undeveloped oil reserve, estimate cash flows based on current prices and use a risk-adjusted present value as the underlying asset. Use extraction costs as the strike price.

• Historical data can be used to estimate variance in oil prices over time.

• Delaying development incurs a cost that can be factored into valuation as a dividend yield or cost of delay.

• A simple example is given to illustrate how these inputs are used in option pricing theory.

Lessons Learned

• Just because an investment doesn't make sense today doesn't mean that exclusive rights to it won't have value in volatile markets.