Incorporating Managerial Information into Valuation of Early Stage Investments

Real options analysis (ROA) is widely recognized as a superior method for valuing projects with managerial flexibilities. Yet, its adoption remains limited due to varied difficulties in its implementation. In this work, we propose a real options approach that utilizes managerial cashflow estimates to value early stage project investments. Our model is based on the assumption that managers can provide pessimistic, likely and optimistic sales and gross margin percent estimates. We introduce a market sector indicator, which is assumed to be correlated to a tradeable market index, which drives the project’s sales estimates. Another indicator, assumed partially correlated to the sales indicator drives the gross margin percent estimates. In this way we can model a cash-flow process that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner. The method requires minimal subjective input of model parameters and is very easy to implement, based on simple managerial estimate.