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We've
been writing about real options for some time now, and
here are excerpts from some of our articles and presentations
that cover topics of interest. See the resources tab
for additional information.
Uncovering
Real Options
How
to Use Your Real Options (pdf
file)
The
Real Options Discipline
Real
Options and the Financial Markets
Three
Reasons Why Real Options Doesn't Apply to Pharmaceutical
Drug Development
The
Craft of Framing Real Options in the Real World: Four
Examples
Uncovering
Real Options
Taking an options-based approach is not simply a matter
of using a new set of valuation equations and models.
It requires a new way of framing strategic decisions.
The questions become less, What will we gain by moving
from point A to point B? and more, If we begin down
the path from point A to point B, what options will
open for us and where will we gain by having those options?
The first step in reorienting strategic thinking, then,
is to identify the real options that exist in investment
decisions.
Uncovering
real options can be tough. Unlike financial options,
real options are not precisely defined or neatly packaged.
But they do exist in almost every business decision,
and they tend to take a limited number of forms. By
understanding these forms, managers can become better
able to spot the options in their own decisions. The
following are hypothetical examples of the most common
types of real options:
Timing
Options. Sales of low-fat ice cream are surging.
Operating at full capacity, the Healthy Cow Creamery
is considering whether to expand its plant. Launching
the expansion would require a big up-front investment,
and the company's managers can't be sure that the sales
boom will persist. They have the option of delaying
the investment until they learn more about the strength
of demand. It may be that the risk avoided by waiting
to invest has a greater value than the sales that might
be forfeited by postponing construction.
Growth
Options. Friend-to-Friend, a company that sells
cosmetics through a network of independent salespeople,
is trying to decide whether to enter the vast Chinese
market. The initial investment to build a manufacturing
and sales organization would be large, but it may lead
to the opportunity to sell a whole range of products
through an established sales network. The investment
would thus create growth options that have value above
and beyond the returns generated by the initial operations.
Staging
Options. The top management team at International
Widget is reviewing a proposal from the senior vice
president of operations to install a new manufacturing
system. The proposal calls for a full, multimillion-dollar
rollout at all factories over the next two years. But
the business benefits of the project remain uncertain.
The company has the option to invest in the new system
in stages rather than all at once. The conclusion of
each stage ill in turn provide further options -- for
continuing, for delaying, or for abandoning the effort.
All these options add value to the proposed project.
Exit
Options. Molecular Sciences has a patent for a promising
new chemical product, but it's worried about the size
of the market opportunity, and it's unsure whether the
manufacturing process will meet government regulations
regarding toxic chemicals. If the company does begin
an effort to commercialize the product, though, it will
have the option to abandon the project if demand doesn't
materialize or if the environmental liability appears
too large. The exit option increases the value of the
project because it reduces the size of the investment
at risk.
Flexibility
options. Cell, Incorporated needs to decide how
to best manufacture its latest cellular telephone. Demand
for the new product is uncertain, although forecasts
indicate that sales will be spread across two continents.
A traditional manufacturing analysis indicates that
a single plant would be much cheaper to build and operate
than two plants on two continents. But the analysis
fails to take into account the flexibility of option
that would be created by building two plants - the option
to shift production from continent to continent in response
to shifts in demand, exchange rates, or production costs.
If the value of the option outweighs the cost saved
by building just one plant, then Cell should invest
in two plants and carry the excess capacity.
Operating
options. Bright Light Software has long contracted
with other companies to produce and package its CD-ROMs
Its sales have grown rapidly in recent years, however,
and now the company is trying to decide whether it makes
sense to build its own plant. If it goes ahead, it would
gain a number of operating options. It would, for example,
have the option to shut down the operations during times
of weak demand and the option to run additional shifts
during times of high demand. The value of these options
adds to the value of the plant.
Learning
Options. Hollywood Partners is planning to release
three movies in the midst of the Christmas season. Before
the films actually open, the studio's executives can't
tell which one will be the biggest hit, so they can't
be sure how to best allocate their marketing and advertising
dollars. But they have an important learning option.
They can release each movie on a limited number of screens
in selected cities and then refine their marketing plans
based on what they learn. They can, for example, roll
out the most popular movie nationwide and give it a
large advertising budget while putting the other films
into more limited release.
From:
"Disciplined Decisions: Aligning Strategy with the Financial
Markets", Martha Amram and Nalin Kulatilaka, Harvard
Business Review, January-February, 1999. www.hbsp.harvard.edu
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The
Real Options Discipline
The goal of strategy is clear - to make investment decisions
that lead to greater shareholder value. But when it
comes to actually achieving that goal, things get fuzzy.
In volatile markets, where prices and demand are always
in flux, it's hard to predict how a particular investment
will ultimately influence a company's value. Senior
executives spend a lot of time structuring their decisions,
tracing out possible implications, assigning probabilities,
and assessing risk.
Rarely,
though, does everyone agree about how an investment
will play out. Different managers draw on different
experiences and have different perspectives, which lead
them to different conclusions. It's hard to sort out
whose answers are the right answers.
In
fact, there is only one right answer: the answer of
the financial markets. The markets are the final arbiters
of an investment's value, and the markets are adept
at calculating uncertainty on value. By applying the
discipline of the markets, managers can avoid basing
important decisions on subjective judgments about the
future. They can incorporate the market's objective
measure of value under uncertainty into their own strategic
choices.
When
does a decision become disciplined? Discipline, in our
view, has three components:
- The
decision is structured, or framed, in terms of the
options it creates.
- All
the relevant information value and risk available
in the financial markets is taken into account.
- Financial-market
transactions are used to acquire options or otherwise
mitigate risk whenever that's economically justified.
Applying
market discipline changes the way managers make decisions,
and it changes the decisions themselves. All kinds of
companies have the opportunity to draw on financial
markets' techniques, benchmarks and information. They
can discipline their decisions and align them with the
investment decisions of the markets. They can close
the gap between strategy and shareholder value.
From:
"Disciplined Decisions: Aligning Strategy with the Financial
Markets", Martha Amram and Nalin Kulatilaka, Harvard
Business Review, January-February, 1999. www.hbsp.harvard.edu
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Real
Options and the Financial Markets
Although
not a new concept, strategic options - the future opportunities
that are created by today's investments - have recently
attracted considerable attention in both the strategy
and decision science literatures. For example, Ron Howard,
one of the pioneers of modern decision science, commented
in 1994 "the prerogative to recognize and create options
is too frequently overlooked in the framing and structuring
of decision problems. This is a failure to recognize
the sequential nature of most decision situations."
Financial
economists, who have labored for the most part independently
of strategists and decision scientists, have struggled
to make the broad sweep of option thinking conform to
the rigors of financial option valuation. When attempting
to apply financial option models to real assets, academics
and practioners immediately run up against a problem:
some of the most significant sources of uncertainty
that affect the value of strategic options are not "priced"
in the financial markets. For many, the confusion on
this issue sometimes gives the appearance that real
options is nothing more than window dressing on concepts
already explored in other fields.
We
would like to propose that real options be defined as
the subset of strategic options in which the exercise
decision is largely triggered by market-priced risk,
a risk that is captured in the value of a traded security.
For example, oil price fluctuations are a market-priced
risk because they are captured in the value of oil futures
contracts. Risks not captured in the price fluctuations
of traded securities are known as private risks. Assets
with market-priced risk are associated with a wider
set of opportunities because one can always acquire,
reduce or reshape the risk through a position in traded
securities.
Our
definition of real options may appear a bit fuzzy, but
this is intentional. Securities markets are changing
rapidly. What is private risk today may well be securitized
in the future. Witness recent developments like telecommunications
bandwidth trading, the creation of weather derivatives,
and the wave of IPOs of young firms without profits.
Each reflects the forces of securitization, the pricing
of additional risk and return in the public arena.
Securitization
also has the effect of deepening existing markets, creating
liquidity, and lowering transactions costs. Despite
this, there will be instances in which the difference
between a real option and a strategic option will become
blurred. A key question for real options - one that
arises from the presence of private risk in most applications
- is the extent to which hybrid models are aligned with
the pricing of risk in the financial markets.
From:
"Strategy and Shareholder Value: The Real Options Frontier",
Martha Amram and Nalin Kulatilaka, Journal of Applied
Corporate Finance, Summer, 2000.
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Three
Reasons Why Real Options Doesn't Apply to Pharmaceutical
Drug Development
Pharmaceutical
drug development is often represented as a sequence
of options. We think that decision analysis is a better
tool for project valuation in this industry.
First,
over two-thirds of drugs are sold in countries with
managed healthcare expenditures. These government programs
have the effect of separating consumer drug spending
from price signals, and so neither quantity nor price
is sensitive to industry or macro conditions. There
are country-specific risks associated with managed care
- such as the recent decision by Germany to cut payments
for prescription drugs by half - but these are private
risks, uncorrelated with other economic indicators.
Pharmaceutical
stocks themselves are not good proxies for project risk
as they are actually portfolios of drug projects. The
private risk of each project is naturally diversified
away at the portfolio level and pharma stocks have lower
stock price volatility (about 25% annually) than most
major industries. Also, the information revelations
that move pharma companies' stock prices will be fairly
different than the revelations that would cause revisions
in the value of a single drug project.
A
second reason that this application does not lend itself
to real options is that there is an enormous amount
of private risk that affects decisions in all stages
of development. For example, in examining proprietary
data for one of the blockbuster drugs of the past decade,
we found that one year before launch the range of uncertainty
about the present value of sales was ± 100%. The reason?
The drug maker did not yet know the wording the regulatory
body would allow on the label. The wording can dramatically
enlarge or restrict the market potential for the drug.
Other
private risk that significantly affects value includes
uncertainty about safety, efficacy, dosage, formulation,
side-effects and so on. The effect of these private
risks for development decisions is larger than the effect
of fluctuations in the market-priced risk, even if the
latter was well-established.
The
third reason we don't believe real options applies to
drug development arises from the type of information
that is gathered in each phase. In the latter phases
the expected value of the drug is hugely positive, and
drugs are seldom abandoned for economic reason. From
Phase III (large-scale human trials) on, there are no
significant options - just points of sudden death. Before
Phase III, information-gathering investments are designed
to rapidly seek the most valuable product performance
and positioning in a multi-dimensional white space.
While
the early phases of pharmaceutical drug development
have some of the features of a strategic option - in
the sense that today's investment creates a set of future
choices - the real options toolkit seems largely irrelevant
to decisions in pharmaceutical drug development. The
industry has been using decision analysis to quantify
its strategic options, which is an appropriate tool
for searching out value and assessing the value of information.
We don't see any pressing need for change.
From:
"Strategy and Shareholder Value: The Real Options Frontier",
Martha Amram and Nalin Kulatilaka, Journal of Applied
Corporate Finance, Summer, 2000.
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The
Craft of Framing Real Options in the Real World: Four
Examples
Framing
is the act of setting up the application, of drawing
out the analogy at the level of inputs and decision
between the expansion option and the financial option.
As these quick examples illustrate, there is a bit of
a craft to the application of real options in the real
world.
The
value of the payoff at Yahoo! During the turmoil
of 2000 and 2001, Yahoo! significantly revised expectations.
Its advertising-based business model was not working
in the downturn of 2001, and a new business model was
not yet in sight. Yahoo!'s stock price fell more quickly
and more deeply than did Amazon's, because without a
clear business model, Yahoo! lost the value of both
its steady business (captured by a discounted cash flow
analysis) and its upside potential (the payoff to any
expansion options.)
The
blended volatility at Omni Media. Omni Media (Martha
Stewart's company) wants to be a mature, nationwide
content company. The firm creates content for Internet,
print, and television. What determines the volatility
of the payoff to an expansion option for Omni Media?
A mix of Internet, content, and traditional publishing
business models. The appropriate volatility captures
the mix of risks from the online and offline worlds.
Using volatility estimates from traditional publishing
may omit the Internet components. Conversely, using
volatility estimates from Internet-only companies neglects
that mature business will have relatively low volatility.
Judgment, and a sensitivity analysis, will be required.
The
option trigger in cable companies. In April 1999
Laura Martin, cable and media equity analyst at Credit
Suisse First Boston, issued a report using real options
to value the assets of cable companies. At the time,
cable companies across the United States were upgrading
the connection to customers' homes to a 750 MHz capacity.
Only 650 MHz had identified uses, and the remainder
was "dark fiber." Using a DCF model, Martin valued the
projected free cash flow of the cable companies she
covered. After adjusting for debt, the DCF estimate
of stock price equaled the trading price.
In
a pioneering analysis, she went on to value the dark
fiber as an expansion option: When the right deal came
along, the cable companies would open up another channel.
The expansion option simply increased the business-as-usual
possibilities. The driver of the exercise decision is
the arrival of an attractive deal for the channel, which
is largely unrelated to the value of the payoff. The
real options analogy is only an approximation. But when
Martin's report was released, cable company stock prices
increased 10 percent to 15 percent, and market values
of cable companies exceeded DCF values for the remainder
of 1999. As this example shows, while the analogy was
not airtight, the equity report made the expansion option
visible, and its value was capitalized into cable company
value thereafter.
The
value decay in online pet stores. In 1999 venture
capitalists funded six very similar companies with hundreds
of millions of dollars, each racing for market share
in the online pet store market.15 The pet companies
felt the pressure-it seemed that with each passing month,
potential market share slipped away to competitors.
Viewed from an options angle, the payoff value was decaying.
It
is straightforward to quantify the effect of value decay
on the expansion option. A sixth variable, the rate
of value decay, is added to the input list. With the
adjustment, the future outcome of S remains uncertain,
but the new variable introduces a downward drift to
the fluctuations, gently lowering the range of future
outcomes. Value decay is very costly to option value.
The implication was that investors grossly overestimated
the value in online pet stores at the time of their
funding. The implication for the management teams was
that there was a reason to rush for market share. With
value decay, waiting leads to a lower and lower payoff.
From
Chapter 4 of Value Sweep: Mapping Corporate Growth Opportunities,
by Martha Amram (HBS Press, 2002). www.valuesweep.com
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