Shareholder Value, Real Options, and Innovation in Technology‐Intensive Companies

We show how central concepts from technology and innovation management (TIM), sequential models of the New Product Development (NPD) process, and the valuation technique of ‘real options’ can be linked, to provide a valuation framework that can be used in the value‐based management of technology‐intensive companies. We introduce a binomial option tree which incorporates the flexibility and the risks inherent in the NPD process into its evaluation in a theoretically correct way and is at the same time simple and easy to use. In this way, our options‐based approach ties the valuation of hitech and life sciences companies closer to the underlying growth opportunities and incorporates much of the ‘gut feel’ of experienced industry practitioners into the valuation. As a consequence, the approach leads to more defensible valuations and allows powerful insights for the value‐based management of technology‐intensive companies. In two numerical examples we demonstrate that the theoretically more sound option tree approach in practice can produce different valuations and lead to different decisions than a simple ‘discounted cash flow (DCF) tree’ approach and has therefore potential to improve managerial decision making. Finally, we describe a real life situation where our options‐based approach was successfully applied in the valuation for the initial public offering of a biotech company.