The discounted cash flow formula (DCF) is of major interest for the social inquiry of capitalization into which the PERFORMABUSINESS team has proposed to delve. Since the 1950s, DCF has become the key tool that equips practices of economic valuation, aids firms and governments in their investment decisions, orients the allocation of resources, and shapes the management of projects. DCF carries a peculiar theory of valuation. It derives the value of a thing from the cash flows (revenues and expenses) that this thing is expected to generate in the future. It also reduces these flows by means of a discount rate, which reflects the idea that the future is worth less than the present, and that uncertainty is worth less than certainty. By doing so, DCF grants greater value to projects whose returns are proximate and predictable. As a consequence, DCF has been blamed to systematically undervalue innovative projects and hence impede their pursuit. Some have further argued that the formula actually misrepresents managers’ practices by failing to take into account the flexibility and learning they are capable of. Others have even suggested that the use of DCF is responsible for managers’ focus on short-term returns and their unwillingness to undertake the kinds of projects that help the organizations — and nations — to which they belong survive and prosper in the long run.
Since the 1980s, a few scholars in corporate finance, economics, strategy, and engineering have proposed to address such criticism by replacing DCF with another approach. Inspired by advances in financial theory (namely the work of Fisher Black, Myron Scholes and Robert Merton), they have attempted to extend options reasoning to the world of “real” (i.e., non-financial) assets and investment decisions within firms. The idea was to envisage an investment made by a firm (e.g., purchasing a lease for coal land, spending in research and development, building a new factory) as an option, in so far as it gives the firm the right, but not the obligation, to take action (mine coal, market a new technology, expand production) at a later stage. This view had two advantages. First, if an innovation project could be thought of as an option, its value would become greater than what DCF would compute — because the capacity of management to adapt and take optimal decisions becomes part of the equation. And, second, the value of the project could be calculated thanks to the tools that had been recently developed for the purpose of pricing of financial options.
In the 1990s, the real options approach sprinkled enthusiasm among scholars, consultants and a few practitioners. But it also raised numerous questions. To what extent can a formula be transposed from the world of financial markets to that of corporate investment decisions? Doesn’t it require too big changes in the ways firms are structured and projects are managed? Isn’t it too complex for users other than MIT-trained financial officers? Do its assumptions — namely, that managers are flexible and capable to make and exercise optimal decisions — eventually hold true?…
We believe that the controversies around DCF and real options provide us with an insightful viewpoint on the performativity of valuation formulas, that is, the worlds that they require building in order to function and the effects that they induce when put in practice. The PERFORMABUSINESS team has hence engaged in an analysis of these controversies. Our methodology relies on two sources of data. First, we are carrying out interviews with academics and practitioners who have been involved in the development of real options. Second, we are conducting a quantitative study of the literature on real options, experimenting with a novel approach which should enable us to account for relations not only between publications (by following citations and hyperlinks for example) but also within them (by looking for the entities that publications figure, and the ways in which they depict and connect them).