Real Options Managing Strategic Investment in an Uncertain World

home
overview
about real options
introduction
faq
about the book
excerpts
endorsements
downloadable spreadsheets
recent press
errata
the authors
about the authors
interviews with the authors
additional resources
links
equity analyst reports
consultants
software

FAQ

 

Over the years we've collected our readers' most frequently asked questions. The inquiries focus on the nature of real options and specific industry applications. Here are some highlights.

A First Look At Real Options
Explain the title of your book.
Tell me more about options.
Why are options so important?
You seem to be suggesting that uncertainty can be a good thing.
Tell me more about real options.
Is this book about strategy or finance?
How do financial options relate to real options?
Do you have to be a rocket scientist to understand all this?
Do the financial markets know about real options?
Who should be using real options thinking?
Where have these ideas been used?
We are already using decision analysis in our firm. Will switching to the real options approach change any decisions we make?
Where can I learn more about the option valuation breakthrough?

Thinking Through the Valuation Model
What is an underlying asset?
Whatinformation is needed to value an option?
What information is NOT needed to value an option?
Why doesn't DCF work for flexible decision-making?
How does the real options approach compare to the alternatives?

Getting the Numbers
When can the Black-Scholes Equation be used to value real options? How about the binomial method?
Tell me more about private risk.
Is the choice between a log-normal and a mean-reverting process for the underlying asset important?
If you increase volatility, the value of the option will increase. However, increasing volatility also decreases the discount rate, lowering the value of the project. What's going on?
I've collected the data and calculated some historical volatilities for three firms I'm studying. These results are very different than the option price volatility information available at the CBOE web site. Which should I use?
Do I need to define a corporate utility function to include private risk in my calculations? Do corporate utility functions differ?
How do I get taxes into a real option valuation?

Industry Applications
Utilities
Water:
Has the real options approach been used to value infrastructure investments in the water industry?

Electricity:
In the summer of 1998 wholesale electricity prices spiked from $20MWh to $5,000/MWh. What was going on? Did the market misvalue the futures prices?
In chapter 16, you do not mention the volatility of revenue, which is dependent on the price of eelctricity. Isn't the volatility important?

R&D, Product Development and Technology
Pharmaceutical R&D:
What is the best approach to valuing a drug in development, during clinical trials?

Negative value to R&D:
Are there applications in which more research and more information leads to a liability instead of an asset?

Technology licenses:
In a Harvard Business Review article (1984), W. Kester defines proprietary options (those owned by your firm) and shared options (those also held by your competitors.) We've got some good technology, but it is not exclusive. How do we "haircut" the value of our technology-based options to get the correct value?

New applications
Filmmaking:
Has the real options approach been applied to valuation and strategy in the film industry?

Online Learning:
What's the real options perspective on the following question: Should a state university expand by investing a large amount of money in buildings, or putting everything on the web and presenting a web-based education?


 

A First Look At Real Options
Explain the title of your book.
When a company invests in a physical asset, they're also acquiring options - opportunities to make decisions in the future, based on the outcome of things that are uncertain today. We call these real options to distinguish them from option contracts traded in the financial markets. Example: the value of a new manufacturing plant includes the option to expand if sales take off and option to abandon if sales die.

>> back to top

Tell me more about options.
In common use, the word option is used to suggest alternatives or choices. For real and financial options, the word has a different meaning.

An option is the right, but not the obligation, to take an action. For example, an option contract is the right to buy (or sell) a stock at a date specified in the future. Options are valuable when there is uncertainty. For example, an option contract traded on the financial exchanges will be exercised (used) only if the price of the stock on that date exceeds the specified price. The value of the contract comes from this upside potential. Real options are created by investment - today's investment creates the right to make a decision later. The value of the investment includes these real options.

>> back to top

Why are options so important?
We live in a world of uncertainty, there's a lot of value in having options to change your mind or update your strategy in the future. Using an options approach a company can change how it faces uncertainty. Options help to limit its losses from bad outcomes and increase the payoff from good outcomes.

>> back to top

You seem to be suggesting that uncertainty can be a good thing.
If you have your options in place, an increase in uncertainty will raise the value of your assets. Here's an example. Suppose you just bought rights to a new technology for $5 million. In six months time you'll know if there is a market for this new product. If the market looks strong you'll put in another $10 million. As of today, the most you can lose is $5 million. However, uncertainty about the value of the market opportunity increases the chance of a great payoff. Uncertainty increases value because it has this one-sided effect.

>> back to top


Tell me more about real options.
Real options is the extension of financial option theory to options on real (nonfinancial) assets. In contrast to the valuation of financial options --where decision-making it is a matter of shopping for the best deal on a specified contract -- the valuation of a real option requires that it be identified and specified. Moving from financial options to real options requires a way of thinking, one that brings the discipline of the financial markets to internal strategic investment decisions.

The real options approach works because it helps managers with the opportunities they have to plan and manage strategic investments. Stewart Myers of MIT coined the term "real options" to address the gap between strategic planning and finance.

"Strategic planning needs finance. Present value calculations are needed as a check on strategic analysis and vice versa. However, standard discounted cashflow techniques will tend to understate the option value attached to growing profitable lines of business. Corporate finance theory requires extension to deal with real options."

Stewart C. Myers, Sloan School of Management, MIT (1984), p. 13.

>> back to top


Is this book about strategy or finance?

As you can see, options thinking is very useful for forming strategy. But options can be very costly to acquire and to maintain or keep alive. You should invest in options with value greater than their cost - and you need the options-pricing tools of finance to do this kind of tradeoff. Also, in markets with uncertainty both strategy and finance are focused on valuing risky assets. This means that the risk/return tradeoff of traded assets should be important benchmarks for corporate assets as well. Using the financial options tools for real options brings this type of discipline to corporate strategy.

>> back to top


How do financial options relate to real options?
We've got a graph in our Harvard Business Review article that summarizes this point. Basically, financial option tools, such as the Black-Scholes equation, can be used when the options are not too complex and there are direct comparisons to traded assets. But for most real-world projects, the imbedded options are too complex and/or there is less direct exposure to traded assets. Valuing the options in real assets requires a somewhat different, and more wide-ranging toolkit.

>> back to top


Do you have to be a rocket scientist to understand all this?
No! Our book has only three equations in it. We wrote so that the power of this way of thinking could be used by general managers. As we've worked with companies, we've developed frameworks and processes that build off of internal systems and knowledge. Some of this is described in Chapter 7 of our book.

Ironically, our book has also attracted rocket scientists because we show the many different applications of this approach. They've got the math, but not a sense of the business potential.

>> back to top


Do the financial markets know about real options?
Financial markets implicitly capitalize real options in the stock price. Here are some data points:

  • Lucent. If you used a traditional analysis based on projections of cashflow from current products, Lucent would be priced at just over $4 per share. Since its spinoff from AT&T, Lucent has been trading far above that amount, often in the range of $70 per share. The difference is the capitalization by the financial markets of Lucent's growth options
  • Amazon.com. This company went public before becoming profitable and announced in its IPO prospectus that it would not be profitable in the near future. Amazon.com is also a growth option play. A large part of the company's value is its strategy to make strategic investments today that create options - opportunities to possibly make further investments in the future. Enhancing Amazon's value is Wall Street's perception that the company has the managerial abilities to execute these options.
  • Cable industry. Laura Martin of Credit Suisse First Boston has used the real options approach to value cable plant. See our downloadable case study.
  • Real estate. Quigg (1993) provides empirical evidence that real estate prices reflect development options.
  • Abandonment options. Berger, Ofek and Swary (1996) demonstrate that the financial markets recognize abandonment options.


>> back to top


Who should be using real options thinking?
Three kinds of managers. First, senior management reads for the vision - particularly how corporate strategy can be aligned to financial market valuation of shareholder value. Second, inside companies, analysts supporting senior management are often handed these ideas from above, or want a way to introduce the power of real options to senior management. Third, managers who communicate externally. Because real options covers uncertainty, strategic alignment and valuation, it integrates and structures many of the issues companies want to communicate to their customers and to Wall Street.

>> back to top


Where have these ideas been used?
The range of applications is extraordinary, including venture capital investment, to drug development, to oil exploration, to IT implementation and to technology licensing. See the reading list by industry application and the FAQs by industry application below. In many industries managers sense that they are making larger and larger investment decisions in the face of greater uncertainty - and so we expect that this approach will continue to have wide application.

>> back to top


We are already using decision analysis in our firm. Will switching to the real options approach change any decisions we make?
Decision analysis (DA) and other tools are very useful and should be used when appropriate. If you've already got the capability built up to use these tools, then the 80/20 rule applies - real options would need to provide a significant improvement before I'd invest in a change. We're not wedded to a particular tool.

However, we've seen decisions change radically after a real options review. Why?

  1. The problem is reframed. Often engineers and others using DA miss the market dynamics. Reframing the problem highlights private versus market-priced risk and puts risk mitigation on the agenda.
  2. Linking decisions to the market-priced risk is a source of competitive advantage. This is the point of our Harvard Business Review article. For example, using DA one might switch from one fuel to another at the wrong time, a potentially costly mistake. In the small margin commodity markets, these mistakes can be deadly.
  3. Risk management. After laying out the risk, managers see how to shape a project and change its risk profile. We check our exposure to market movements for the traded derivative securities we hold, but often fail to do the same for real assets.

>> back to top


Where can I learn more about the option valuation breakthrough?
Two wonderful histories of the breakthrough research have been written by Peter Bernstein: Capital Ideas: The Improbable Origins of Modern Wall Street (1992) and Against the Gods - The Remarkable Story of Risk (1996). The Nobel Prize web site, http://www.nobel.se/, also has a good description of the work by Fischer Black, Robert Merton and Myron Scholes.

Good introductions at the MBA level can also be found in Brealey and Myers (1996), Grinblatt and Titman (1998), and Hull (1997). Introductions at the undergraduate level are in Brealey, Myers and Marcus (1998), and Hull (1998).

>> back to top

 

Thinking Through the Valuation Model
What is an underlying asset?
Suppose you hold a call option to purchase IBM stock in three months. The value of this contract depends on the value of IBM stock, the underlying asset. Underlying assets for a real option are similar, they are traded securities in the financial market whose fluctuations largely determine the value of the option. For example, the underlying asset for oil exploration is the appropriate oil futures contract or index of contracts. Traded contracts price in teh convenience yield while spot prices do not include the value of this attribute. Note that product prices (such as the spot price of oil) or cashflows (such as profits) are not assets. Framing must include the transformation of these cashflows to uncertain assets.

>> back to top


What information is needed to value an option?
The following inputs are the only information you need value an option:

  • The current value of the underlying asset, which is observed in the market.
  • The time to the decision date, which is defined by the features of the investment.
  • The investment cost or exercise price (also called the strike price), which is defined by the features of the investment.
  • The risk-free rate of interest, which is observed in the market.
  • The volatility of the underlying asset, which is often the only estimated input.
  • Cash payouts or noncapital gains returns to holding the underlying asset, which are often directly observed in the market, or sometimes estimated from related markets.

An example: What is the value of an option to buy TV-Sat in six months time at 125% of today's price? TV-Sat's stock trades on a major exchange. The inputs required to evaluate the option are: the current value of TV-Sat; six months, the length of time to the end of the option; the guaranteed purchase price (125% of the current price); the risk-free rate of interest,5%; the annual stock price volatility of TV-Sat, 35%; and the dividends expected to be issued by TV-Sat during the next six months.

>> back to top


What information is NOT needed to value an option?
Information that is not needed to value an option contributes greatly to its power. The following information is not used in the real options approach:

  • Probability estimates are not needed because these are captured by the current value of the underlying asset and the volatility estimate.
  • An adjustment to the discount rate for risk is not needed because the valuation solution is independent of anyone's taste for risk.
  • The expected rate of return for the underlying asset is not needed because the value of the underlying asset and the ability to form tracking portfolios already capture its risk/return tradeoff.
  • The expected rate of return of the option is not needed because the option is valued directly by dynamic tracking.

>> back to top


Why doesn't DCF work for flexible decision-making?
Most companies use some form of discounted cash flow to value investment opportunities. However, using the discounted cashflow approach to value contingent investment decisions, the kinds of decisions facing managers, produces a "show-stopping" dilemma. Consider the option to abandon. If the option is used, the asset is abandoned and there is no further risk. If the option is not used, there is risk to holding the option and the asset. No single discount rate can bring these different risks back to the present, and this problem has no remedy inside the discounted cash flow framework.

>> back to top


How does the real options approach compare to the alternatives?
The Head-to-Head Comparison: Many corporations have a collection of tools to better understand the effect of uncertainty on large capital investments, and successful consulting firms have been built to bring these tools to their clients. Many of these methods use discounted cash flow, and suffer from the discount rate dilemma mentioned above. Here's a quick rundown on how the methods compare to the real options approach on other dimensions.

  • Scenario analysis. Modifying a discounted cashflow analysis with scenarios is the first step to incorporating uncertainty, but each scenario remains fixed on a single future outcome and investment plan. There is no clear way to reconcile, aggregate, or choose between scenarios.
  • Decision analysis. Often called decision tree analysis, decision analysis is a very straightforward way to lay out future decisions and sources of uncertainty. Decision analysis, however, relies on subjective assessments of probabilities, subjective discount rates, and preferences about the objective.
  • Simulation analysis. Simulation analysis lays out thousands of possible paths for the uncertain variables. It is very difficult to handle decision opportunities that arise before the final decision date in a simulation model. In addition, it is often hard to interpret the results of a simulation analysis because simulation models use a subjective discount rate and do not incorporate financial market information.
  • Real options. In contrast, real option valuation is based on objective inputs, and a precise list of which inputs are needed and which are not. Those inputs are used in a way that produces market values and the real options approach guides the user on where to look and why. Experienced users of the real options approach see the patterns, the types of options, and the important sources of uncertainty. In addition, the real options approach provides a framework for revising expectations and for managing investments over time. The optimal exercise of managerial options requires frequent scans of the environment and updates of important information.

>> back to top

 

 

Getting the Numbers
When can the Black-Scholes Equation be used to value real options?How about the binomial method?
The choice of solution method depends on the particular features of the application. Some applications can only be solved using certain solution methods. For example, the Black-Scholes formula does not work for American style options.

The Black Scholes Equation. The partial differential equation that Black and Scholes studied mathematically defines the evolution of the value of the option in terms of the value of the underlying asset, its volatility, and the risk-free rate of return. Different partial differential equations are specified to reflect the specific features of the option, and not all partial differential equations have an analytical solution. (In an analytical solution the option value can be written as a function of the inputs.) The Black-Scholes equation is an elegant, single-equation solution to one particular partial differential equation. When an analytical solution is available, it is a simple matter to program the equation(s) into a spreadsheet. The Black-Scholes equation is well suited for simple real options, those with a single source of uncertainty and a single decision date.

Numerical Methods. When the application is more complex and includes particular features of a real asset such as multiple sources of uncertainty or many decision dates, analytical solutions cannot be obtained. Specialized mathematical tools known as numerical methods are required.

The Binomial Model. One approach for handling complex real options, risk-neutral valuation, was introduced by John Cox and Stephen Ross in 1976 and later applied by these authors and Mark Rubinstein in a very useful manner in the binomial option valuation model. (See Cox and Ross (1976) and Cox, Ross and Rubinstein (1979).) The key insight of the risk-neutral approach is that because the option values are independent of everyone's risk preferences, the same valuations will be obtained even when we assume that everyone is indifferent to risk, or risk-neutral. This assumption simplifies calculations enormously because we do not need to estimate the premium for risk in the discount rate, because no investor requires compensation for taking on risk. A particularly simple, yet robust, implementation of the risk-neutral approach is the binomial option valuation model, in which the underlying asset moves up or down by a small amount in each short period.

There are three advantages to the binomial option valuation model:

  1. It spans a large range of real option applications, including those with some complexity.
  2. The approach is comfortable for many users because, although it is consistent with the option valuation breakthrough, it retains the appearance of discounted cash flow analysis.
  3. Uncertainty and the consequences of contingent decisions are laid out in a very natural way; the binomial model generates good visual images.

 

>> back to top


Tell me more about private risk.
There are several aspects to private risk:

  • Number of sources. Everyone tends to include quite a few, but it is not always clear that they have economic impact. We're in the process of developing a methodology for reduction in the number of sources of private risk.
  • Magnitude of the economic consequences. If the economic consequences of private risk are small, then one need not worry about corporate attitudes towards risk and the private risk should be folded into the analysis and discounted at the risk-free rate. You can use a binomial model with two sources of uncertainty for example.
  • The discount rate issue. If the private risk has large economic consequences, some academics argue that corporate risk aversion and a risk-adjusted discount rate should apply. Others argue that on should use outputs, such as a VAR-type analysis to make decisions about the cost/benefits of mitigation, but continue to fold in private risk under the risk-neutral framework.

Overall, one needs to be dogmatic about using market-based perspectives throughout the framing steps. It is too easy to "over model" private risk, including too many sources and too much detail.

>> back to top


Is the choice between a log-normal and a mean-reverting process for the underlying asset important?
Professor Robert Merton of HBS, and the 1997 Nobel Prize winner in Economics, has the following test question in his MBA Finance class: Suppose you have two option contracts with the same terms. The first contract is on "soap" (or some product) and the underlying asset is a future contract on soap. Soap is known to have a geometric brownian motion (GBM) process. The second contract is on "butter" and the underlying asset is a futures contract on butter. Butter has a mean-reverting process. Sigma is the same for the two futures contracts. Which option is more valuable?

Answer: The two options have the same value. In this case, the futures contracts price in the appropriate stochastic process. The futures contracts themselves have a GBM process. The point is that the stochastic process is priced into the asset value. This is just the same as with stocks. Asset values capitalize information, spot prices reflect current supply and demand.

Hence, we think the issue about choice of stochastic process for the underlying asset is most often a framing issue, not one of statistics. There will be occasions in which the underlying stochastic process must be specified, but these are more rare than most users think. For one application in which a choice had to be made see Tufano and Moel (1998)

>> back to top


If you increase volatility, the value of the option will increase. However, increasing volatility also decreases the discount rate, lowering the value of the project. What's going on?
This is a comparison about the effects of volatility in two different valuation models. The options-based valuation model includes decision making opportunities. When managers can avoid losses, increased volatility only raises the upside potential. In a discounted cash flow (DCF) model, increased volatility increases the discount rate, holding all else constant. But can you really hold all else constant? For example, if you used the CAPM to calculate the discount rate, you'll need to re-estimate beta under the new volatility regime. You might also want to check your cashflow forecast. Thus, the total effects of volatility on a DCF model are not entirely clear, and nothing about the model gets managers to systematically think about the effects of volatility.

>> back to top


I've collected the data and calculated some historical volatilities for three firms I'm studying. These results are very different than the option price volatility information available at the CBOE web site. Which should I use?
There are two different ways to estimate volatility. Historical data provides an estimate of the volatility experienced in the past. This often is a good guide to the future as well. Implied volatilities (those calculated from traded options) are the market's forecast of future volatility. In theory these are precisely what you need, so use them!

When comparing volatility estimates, make sure you've got the numbers right:

  • Use at-the-money options for the best estimate of implied volatility. The volatility estimate will vary across strike prices, and the at-the-money estimate contains fewer of the confounding effects.
  • Keep your units are straight, so that you are comparing annual volatility to annual volatility and so on.
  • Adjust historical stock price series for dividend payments before calculating returns.

>> back to top


Do I need to define a corporate utility function to include private risk in my calculations?Do corporate utility functions differ?
Corporations maximize value, but face constraints such as cashflow, earnings targets, and so on, that make managers risk averse. See two good articles, one by Froot, Scharfstein and Stein in Harvard Business Review and another by Tufano in the Journal of Applied Corporate Finance.

A key question for private risk is magnitude. If the incremental risk of the project significantly change the corporate profile, then some have argued that adjustments should be made to the option valuation model. If the incremental risk does not change the corporate profile then continuing with the option valuation approach should be fine.

>> back to top


How do I get taxes into a real option valuation?
Taxes are down two layers in an option calculation. Starting from the top: an option depends on an underlying asset. If this asset is present value of future cashflow, then taxes would go in the cashflow model. The effect is to decrease the present value of future cashflow, an input into the option calculation.

Sometimes the underlying asset is a price, such as when futures contracts are used to obtain an oil price. Suppose the solution method was the binomial model. There would be an event tree (oil price movements), a cashflow tree (calculation of cashflow per oil price) and a valuation foldback. In this solution method taxes are folded into the asset as the valuation rolls back.

>> back to top

 

Industry Applications
Utilities
Water:
Has the real options approach been used to value infrastructure investments in the water industry?
The water industry is undergoing deregulation, spurring a need for asset valuations that are aligned with water pricing. This is the same phenomena that has previously occurred in the electricity and gas industry, and articles about the financially-engineered products and asset valuation in these industries might be of use. Enron has a business unit active in the water industry, so expect an invasion of real options thinking.

>> back to top

Electricity:
In the summer of 1998 wholesale electricity prices spiked from $20MWh to $5,000/MWh. What was going on? Did the market misvalue the futures prices?
The electricity market is not fully deregulated, constraining supply in response to high prices. This causes electricity price spikes to reach higher levels and to last longer than would occur in a fully deregulated market. Also, transmission capacity and geographical layout plays an important role, placing supply response constraints on the system. These two factors can cause spot prices to deviate from the market's forecast in the futures price. As market participants learn more detailed information about how these two factors affect spot price dynamics, the futures and spot prices will line up better. As we note in our book (page 95, "Electricity Trades Shocked by Black-Scholes"), market participants learn fast.

>> back to top


In chapter 16, you do not mention the volatility of revenue, which is dependent on the price of eelctricity. Isn't the volatility important?
The analysis we presented is about acquiring a physical asset to produce steam. Because the physical asset came in tree types, we focused on those. However, expanding the set of alternatives would be the right thing to do, particularly to include producing steam from electric powered boilers or possibly buying steam from the electric company. The importance of these alternate investments depends on the relative levels and volatility of gas, oil, and electricity prices.

>> back to top

R&D, Product Development and Technology
Pharmaceutical R&D:
What is the best approach to valuing a drug in development, during clinical trials?
This is an active area of research, so expect more soon on this topic. R&D projects can be viewed as investments that create options. The value of a drug in the R&D stage can be obtained through a nested options valuation model. See Chapter 11 of Amram and Kulatilaka for an overview, and their Guide to the Literature for some pointers to other papers.

>> back to top

Negative value to R&D:
Are there applications in which more research and more information leads to a liability instead of an asset?
In the options approach, R&D creates information used by managers to make better decisions. However, if the same information allows another party to make a better decision, the net value of the information might be negative. For example, tobacco companies funded research on the effects of smoking, and then withheld the results. They may have used this information for internal decision making, but the legal system also allowed prosecutors to use this information (once discovered) to make other decisions.

So the key question is about decision rights. If R&D creates information that can only be used by your company, the options results as described in our book apply. If R&D also creates information that others can use, then you need to ask whether they may make decisions that destroy value.

>> back to top

Technology licenses:
In a Harvard Business Review article (1984), W. Kester defines proprietary options (those owned by your firm) and shared options (those also held by your competitors.) We've got some good technology, but it is not exclusive. How do we "haircut" the value of our technology-based options to get the correct value?
First, the core technology might not be exclusive, but what you do with it might develop an exclusive implementation. Thinking through all the subsequent investments might redefine the option from shared to proprietary.

Second, you might be interested in some recent papers by Steve Grenadier at Stanford who has been tackling the issue of industry dynamics when all players hold options, both shared and proprietary.

>> back to top

New applications
Filmmaking:
Has the real options approach been applied to valuation and strategy in the film industry?
We know of at least one project underway in this area, so expect more soon on this topic. Basically films in production can be valued as option-creating investments. The application frame is similar to investments in early-stage oil exploration or early-stage pharmaceutical R&D. Firm libraries are portfolios of options, and are similar to portfolios of patents. In each case an initial investment has been made that creates an option to make follow on investments.

>> back to top

Online Learning:
What's the real options perspective on the following question: Should a state university expand by investing a large amount of money in buildings, or putting everything on the web and presenting a web-based education?
Although, for many companies, certain types of experiences and costumer solutions can be delivered through the internet, without entry barriers created by bricks and mortars, there is enormous competition through rapid technology change on the web. It is expensive to keep web services on the leading edge. This suggests that a state government might not be the right vehicle to be creating on-line education. It is now a national market. Perhaps vouchers for accredited on-line education would be better than state ownership.

Traditionally, many universities have not been able to fully exploit the options created by their facilities. For example, summer school is there, but underutilizes the physical plant. Special courses don't fill the gap. Perhaps the marketing cost or organizational structure increases the cost of exercising these options. Face to face contact is the most effective form of learning. You don't get it on the web.

>> back to top





 

 

 

 


buy