Will Real Options Take Root?

Why companies have been slow to adopt the valuation technique.

Real options only works for tradable assets. A common objection to real options is that it doesn’t work when the underlying asset isn’t tradable — that is, when the asset price over time can’t be observed in the financial markets. Jeffery, however, points out that the key parameter in a real-options valuation is volatility, and that in order to estimate volatility, you need appropriate and sufficient data — such as historical R&D data, actuarial information, and so on. If data doesn’t exist, it can be created. How? In a nutshell, by identifying the assumptions driving the bottom line of a project, then identifying the risks associated with those assumptions, then creating a statistical distribution of risk using Monte Carlo simulations. “It is possible to vary the risk drivers in a project and simulate financial-market data,” says Jeffery. “If you take the lognormal of that distribution, the standard deviation is the volatility.”

Real options discounts management realities. Is the strength of real options also its Achilles’ heel? Critics say that because real options don’t expire according to contract as financial options do, managers can’t be counted on to pull the plug on a project (exercise an “abandonment option”) when they should. Also, projects assume lives of their own, and may not be easy to kill (see “Reality Check,” CFO, September 2001). This reluctance to cut projects may be “coupled with a love for the ideation of new projects — look at all these options we’re creating!” says Amram.

On the other hand, companies often yank NPV-sanctioned projects, while real options provides a detailed map for making such decisions, with far greater precision. Arguably, adopting a real-options approach would promote greater discipline in project management. But the approach won’t take if an organization doesn’t embrace change, or if compensation systems aren’t aligned accordingly. A manager can’t be expected to exercise a growth option, for example, if she’s being compensated for keeping costs down. “Until we tackle these sorts of organizational process and governance issues, the lone analyst can’t really do much more,” says Amram. “I don’t see companies at all interested in changing business processes right now,” she adds. “Everybody’s glad they have jobs.”

So what is the near-term prognosis for real options? “I think there have been a lot of gains, from a strategic dimension, in terms of what we call real-options thinking,” says the University of Maryland’s Triantis. “I don’t think anyone’s defecting from that. However, the next step of adopting a more analytic real-options tool to evaluate projects is generally progressing at a much slower pace, and has even stalled at some companies.” As for the ultimate goal — an integrated value-based management system that analyzes a company’s portfolio of real options — “nobody’s there yet.”

“Real options is sometimes a little like an extreme sport — people look at it and say, ‘Wow, that’s really neat,’” says Triantis. “It’s fun to watch, but when you actually sit down and try to do it yourself, it’s not so easy.”

Sidebar: What Are Your Options?

A real option is the right, but not the obligation, to take an action that will either help maximize the upside or limit the downside of a capital investment. Like financial options, real options can be valued using options-pricing models. There is general agreement on the basic types of real options, but every taxonomy is different: some experts group options into growth and flexibility options; others add contractual and insurance options as categories; still others sort them into growth, deferral/learning, and abandonment options. The following list of common real options and sample scenarios is adapted from Real Options: Managing Strategic Investment in an Uncertain World, by Martha Amram and Nalin Kulatilaka (Oxford University Press, 1998).

1. Waiting-To-Invest Options.

The value of waiting to build a factory, say, until better market information comes along may exceed the value of immediate expansion.

2. Growth Options.

An entry investment may create opportunities to pursue valuable follow-on projects.

3. Flexibility Options.

An option to reallocate resources or switch has value. For example, building two plants instead of one to serve markets on two continents creates the option of switching production from one plant to the other as conditions dictate.

4. Exit (or Abandonment) Options.

The option to walk away from a project in response to new information increases the value of the project.

5. Learning Options.

An initial investment creates better information about a market opportunity and whether more capacity should be built out.

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