Once an obscure mathematical tool, options and option valuation have entered the mainstream. Long routinely applied on trading floors, the Black-Scholes model for valuing options won the 1997 Nobel Prize for economics. Yet despite the fact that senior managers realize that traditional analytical methods such as net present value (NPV) and economic profit (EP) have been responsible for systematic underinvestment and stagnation, options have penetrated the decision-making processes of large corporations more slowly.

For NPV and EP ignore an important reality: business decisions in many industries and situations can be implemented flexibly through deferral, abandonment, expansion, or in a series of stages that in effect constitute real options (Exhibit 1). Recognizing real options can help decision makers assess the profitability of new projects and understand whether and when to proceed with the later phases of projects that have already been initiated, particularly when they are close to breakeven. Real options are especially valuable for projects that involve both a high level of uncertainty and opportunities to dispel it as new information becomes available.¹

Although the overall concept of real options is clear, their specific benefits for individual businesses are not. To date, most attempts to apply real options...