Real Options = Real Value

Real Options Analysis Accommodates Uncertainty

Every day, companies “value” projects using a technique that implicitly assumes the world stands still. Markets never change. Consumer demand never rises or falls. New technologies rarely emerge. And lessons are hardly ever learned. Why? Because one of the best ways to value projects—real options analysis—is flying somewhere under the corporate radar.

Imagine that a major oil and gas company purchases rights to explore a new oil field and invests $5 million to build a small staging platform to begin exploratory drilling. No oil is discovered. The company invests another $10 million to expand the platform. Again, no oil. Another $15 million is invested to upgrade the drilling equipment, and still no oil.

Sound irrational? Far-fetched? Surely the competence of the management team in this scenario would be called into question. How could new information derived in the early exploratory phases not factor into the decision to either defer development or abandon a project altogether? Why wouldn’t the management team muster all of its resources to make well-informed decisions and then alter strategies accordingly?

Clearly, this is an exaggeration, but it raises an important question: Why do companies continue to value projects using traditional techniques such as discounted cash flow (DCF), which are inherently flawed? They assume that no new information will come in, and if new information does happen to arrive, the company is not in a position to change course. If the project net present value (NPV) is positive, it is essentially a green light to move forward regardless of future events.

Lately, an alternative valuation approach—real options analysis, or ROA—has been gaining both credibility and supporters in corporate boardrooms. Based on traditional financial theory, real options analysis offers a way to accommodate time progression and previously unknown factors (as they become known) and use them to determine project investment. Unlike the more traditional techniques, real options analysis explicitly accounts for future flexibility. Rather than relying solely on management experience or “gut instinct” to move projects forward, companies can reach the decision with mathematical certainty.

What Are Real Options?
A real option is the right, but not the obligation, to take an action at a predetermined cost for a predetermined period of time. The basic types of real options include:

• Option to defer, expand or contract. This refers to altering operating scale depending on market conditions, including shutting down temporarily and restarting when conditions become favorable. For example, if demand for whole-grain snacks is greater than forecasted, a manufacturer can expand production capacity.
• Option to abandon or terminate unprofitable projects. For example, a chemical company with a patent for a new chemical product has begun to commercialize the product, but the manufacturing process does not meet environmental regulations regarding toxic chemicals. The company can terminate the project.
• Option to switch, change inputs or outputs. This option is generally used in response to price changes in the inputs or outputs. For example, a toy manufacturer may want to switch production plans to manufacture a toy in high demand.
• Option to pilot. This refers to starting with a prototype project and, if successful, following up with a full-scale project. This is equivalent to test marketing before investing in full production—as in the old vaudeville test: “If it’ll play in Peoria it'll play anywhere.”
• Option to stage. The company breaks up its investment into incremental phases, where the payoff occurs only after the project is completed. For example, investing in R&D and commercialization processes for bringing a new drug to market.
• Option to grow. This involves investing in an initial market, product line or technology to develop a platform for future growth opportunities. For example, telecommunications companies are developing fiber-optic cable networks to deliver content today and to exploit future opportunities.
• Compound options. These are options on options—combinations of all options where the value of an earlier option is affected by the value of options later in the investment.

Real Options Have Real Value
Real options—like their counterparts in the financial markets—have real value. That’s why an analytical tool such as DCF, which fails to recognize the value of options, will systematically undervalue investment opportunities. In certain situations, this is not a big concern. For example, a DCF analysis is applicable in situations where the analysis returns a large, positive net present value, the execution seems fairly straightforward, and the results do not necessarily require any further validation. Also, when there is certainty surrounding an investment—for example in a “cash cow” business—DCF is an acceptable approach.

However, in other situations, real options analysis can more accurately assess the nature of the investment, and therefore provide a better basis for the investment decision. For example, ROA is preferred when the investment decision hinges on the outcome of a future event, or when there is enough uncertainty to defer the investment decision (see sidebar: From ROA to RFID). Also, companies use real options analysis when future growth is a significant source of the investment’s value, when a traditional DCF analysis returns a low or slightly negative net present value, and when the options associated with the investment could change management’s decision from “no go” to “go.”

Essentially, real options analysis is ideal for companies in high-growth industries where there is a great deal of uncertainty and the investments are both large and strategic. High tech, venture capital, pharmaceuticals and oil exploration all qualify and, interestingly, all are early adopters of real options analysis.

Finally, it is not always necessary to choose one approach over the other; companies can combine the two. Far from being a replacement for DCF analysis, real options can be an essential complement, and a project’s total value encompasses both, explains Roger Smith, founder of CTOnet.org. 1   Between high-risk projects and obvious profitable projects is the option zone where DCF valuations clash with management intuition (see figure). In these situations, ROA becomes an invaluable mediator.

Using ROA to “Value” IT Initiatives
Real options analysis can rescue investments with negative NPV but high options value. For example, researchers used a real options approach to value the IT initiatives of a large U.S. utility firm.  2    With 31 IT initiatives being considered for funding, the company first developed a base-case DCF valuation for each project and then reevaluated them using real options analysis. The results were noteworthy. The utility company uncovered $261 million in hidden options value over the base DCF total value of $172 million. In addition, seven projects with negative NPVs (and at risk of being rejected) had positive values under real options analysis. Two of the seven contained embedded options values of $59 million and $63 million, and one of the seven had the highest value of all 31 projects under consideration.

Perhaps more significantly, this example highlights how real options analysis has moved beyond valuing a single investment to optimizing a portfolio of investments. A key component of the analysis was identifying the interdependencies among the IT initiatives not only to calculate the true total value of the portfolio, but also to prioritize the initiatives and sequence their implementations given the existing technological and budgetary constraints. In this way, the utility’s CIO can employ real options analysis to behave much as a venture capitalist—reviewing the merits of an integrated project portfolio and allocating funding to each project based on its value to the overall portfolio.

Taking this concept a step further, to live up to the demands of more sophisticated financial markets, CEOs must offer a convincing story of real value creation—not just within the individual company but in the overall market segment. This goal must govern their behavior from the earliest stages of the value chain on and requires a new mindset. Increasingly, executives are using real options analysis to invest in projects (and acquisitions) that will lead to real market value.

Make It an Option
Real options analysis is gaining both credibility and supporters as a way to value growth opportunities. Although most companies are not yet prepared to abandon their DCF analyses altogether, nor should they, more are willing to consider ROA as a complement to DCF. In our experience, companies that rely solely on discounted cash flow analysis risk missing out on promising growth opportunities—first underestimating the value of their projects and then not investing in them.

Companies that use real options analysis will select better projects while controlling risk. Those that go a step further to employ a real options approach will develop a venture capitalist mindset and manage the entire lifecycle of a project—with gate reviews, go or no-go decisions, and constant reassessment of following a given path. Rather than throwing resources at a failing project, companies can exit in a timely fashion.

A global consumer goods manufacturer was evaluating ways to respond to Wal-Mart’s now-famous RFID announcement. By 2006, Wal-Mart’s top 100 suppliers are required to use radio frequency identification (RFID) tags on their cases and pallets.

The manufacturer initially used a DCF analysis to model its response to the RFID requirement, developing three scenarios. In the first scenario, all volume was RFID tagged for distribution center delivery, with no assumption of retailers’ downstream infrastructure to track pallets and cases. In the second scenario, only goods destined for Wal-Mart’s distribution centers were tagged, with Wal-Mart providing some of the downstream infrastructure to give the manufacturer visibility of its goods in Wal-Mart’s supply chain. In the final scenario, all volume was tagged for all supply chain routes. In this scenario it was assumed that all retailers would be RFID compliant, thus giving the manufacturer visibility into the downstream supply chain to see out-of-stocks, finished goods inventory and unsaleables. All three scenarios returned negative NPVs, and the model provided little guidance about how to address Wal-Mart’s directive.

Skeptical of the DCF outcome, the manufacturer turned to ROA. Wal-Mart’s RFID directive was well-suited to a real options analysis. There was a great deal of uncertainty (RFID technology standards had not been defined), a steep learning curve with probable course-corrections along the way, and the value of the investment was based on future growth opportunities rather than current cash flow. Using a decision-tree approach, company executives soon discovered hidden sources of value in the RFID project, which they would not have found using the DCF technique (see figure). The benefits included the option to expand more aggressively to realize benefits from reductions in unsaleable goods, out-of-stocks, labor and inventory holding costs. Indeed, the analysis confirmed what the manufacturer suspected—that the net option value of pursuing an investment in RFID technology was positive and a pilot should move forward.

In addition, the real options analysis provided insights beyond those of a limited DCF framework. For example, it identified critical decision points in each scenario, outlined ways to recognize the decision points when they appeared, and highlighted potential paths forward. The analysis also summarized the criteria for evaluating a decision point, and determined what targets must be met to continue down the investment path. In short, the real options model laid out a comprehensive RFID playbook, providing the company with its best current understanding of a full range of options related to RFID technology.

¹ Roger Smith, “Applying Options Theories to Technology Management Decisions,” CTOnet.org, 2004.
² Indranil Bardhan, Sugato Bagchi and Ryan Sougstad, “A Real Options Approach for Prioritization of a Portfolio of Information Technology Projects: A Case Study of a Utility Company,” 37th Hawaii International Conference on System Sciences, 2004.

Consulting Author

C. Prasanna Venkatesan is a consultant in A.T. Kearney's Chicago office.

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