There are a number of good introductions to real options (see the web resources for a full listing). Here is the starter from Expectations Investing: Reading Stock Prices for Better Returns by Alfred Rappaport and Michael Mauboussin. (HBS Press, 2001, Chapter 8) Mauboussin is the Chief Investment Strategist at Credit Suisse First Boston, and you can read a thought piece on real options he wrote for money managers called Get Real.

"The real-options approach applies financial options theory to real investments, such as manufacturing plants, product line extensions, and research and development. A financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price. Analogously, companies that make strategic investments have the right, but not the obligation, to exploit these opportunities in the future.

Real options take a number of forms, including the following:

• If an initial investment works out well, then management can exercise the option to expand its commitment to the strategy. For example, a company that enters a new geographic market may build a distribution center that it can expand easily if market demand materializes.

• An initial investment can serve as a platform to extend a company's scope into related market opportunities. For example, Amazon.com's substantial investment to develop its customer base, brand name and information infrastructure for its core book business created a portfolio of real options to extend its operations into a variety of new businesses.

• Management may begin with a relatively small trial investment and create an option to abandon the project if results are unsatisfactory. Research and development spending is a good example. A company's future investment in product development often depends on specific performance targets achieved in the lab. The option to abandon research projects is valuable because the company can make investments in stages rather than all up-front.

Each of these options - expand, extend, and abandon - owes its value to the flexibility it gives the company. Flexibility adds value in two ways. First, management can defer an investment. Because of the time value of money, managers are better off paying the investment cost later rather than sooner. Second, the value of the project can change before the option expires. If the value goes up, we're better off. If the value goes down, we're no worse off because we don't have to invest in the project.

Traditional valuation tools, including discounted cash flow, can't value the contingent nature of the exploitation decision: "If things go well, then we'll add some capital."