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

introduction

 

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

>> back to top

 

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

>> back to top

 

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.

>> back to top

 

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.

>> back to top

 

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

>> back to top

 

 

 

 


buy