Will Real Options Take Root?

Why companies have been slow to adopt the valuation technique.

And why shouldn’t they? Options, after all, are indeed everywhere. They can have considerable value, and that’s what NPV analysis overlooks. Discounted cash flow has its roots in stock and bond valuation, as Brealey and Myers remind us, and investors are necessarily passive. Applied to real assets, NPV assumes passive management; the end result is known in advance, and managers aren’t expected to add significant value to a project.

Real-options valuation, by contrast, recognizes that managers can and do obtain valuable information after a project is launched, and that their informed actions can make a big difference. Thus, real options seeks to uncover and quantify a project’s embedded options, or critical decision points (see “What Are Your Options?” below). The greater the uncertainty and flexibility, the greater the value of management’s options. Indeed, some say that NPV will increasingly be viewed as a narrow subset of real options — one applying to projects with little or no uncertainty and flexibility.

“Discounted cash flow is going to look at an average scenario,” comments Triantis. “But if you talk to any manager, that’s not how they think. They think about contingencies — what’s going to happen, how would we react. And even if they don’t think that way, once it’s presented to them that way, they say, ‘Yeah, that’s the way we should be thinking.’”

Increasingly, that’s the way managers are thinking in industries characterized by large capital investments and quite a bit of uncertainty and flexibility — particularly oil and gas, mining, pharmaceuticals, and biotechnology. Companies in those industries also have plenty of the market or research-and-development data needed to make confident assumptions about uncertainties in real-options analysis. Plus, they have the sort of engineering-oriented corporate culture that isn’t averse to using complex mathematical tools.

That’s not to say, however, that real options is pervasive in those industries, says Gardner Walkup, a partner and expert on real-options valuation in the Menlo Park, California, office of management-consulting firm Strategic Decisions Group. “These are obviously huge organizations,” says Walkup of the mainly Fortune 100 energy companies that are his clients. “There are pockets within each of the organizations that feel very comfortable with the paradigm.”

Although Walkup says real options is not by any means “the silver bullet that’s going to answer everything,” the technique is “at the point where it’s within the lexicon of many companies and industries.” The latter, in addition to the ones cited above, include automotive, aerospace, consumer goods, industrial products, and high tech. Intel, for one, is training finance employees in real-options valuation, and has used the technique to analyze a number of capital projects.

Fertile Fields

Real-options analysis could gain currency via its application in a number of functions that aren’t industry-specific — such as supply-chain management. Inventory, for example, can be regarded as a real option, says Triantis, albeit a costly one. Build-to- order models, flexible assembly, contract manufacturing, and procurement contracts all offer numerous options that can be exploited. In high tech, as computer components become more commoditylike, with futures, options, and spot markets developing for items like memory chips, supply-chain managers will need to become skilled financial engineers, predicts Triantis. Real options could become one of their most valuable tools.

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