Thirty years after the debut of the famous Black-Scholes formula, and 26 years after MIT professor Stewart C. Myers coined the term, real options has yet to catch on at most companies. Recent evidence, in fact, suggests the valuation technique may be losing traction. In 2000, Bain & Co. conducted a survey of 451 senior executives across more than 30 industries regarding their use of 25 management tools. Just 9 percent used real options, which ranked next to the bottom on the list (only market-disruption analysis, a New Economy technique, scored lower). And whereas the average defection rate for all tools in the study was 11 percent, 32 percent of real-options users abandoned the technique in 2000. Only two other tools had higher defection rates.
Real options dropped out of Bain's latest survey, which was released in June. Meanwhile, discouraging news also came from a 2002 survey of 205 Fortune 1,000 CFOs by Colorado State University professor Patricia A. Ryan. That survey found real options trailing a field of 13 "supplementary" capital-budgeting tools. Only 11.4 percent said they used it, compared with 85.1 percent for sensitivity analysis and 66.8 percent for scenario analysis. As for "basic" capital-budgeting tools, net present value (NPV) topped the list at 96 percent.
Such results may be sobering for champions of real options, who have touted the technique as the most important capital-budgeting tool in decades. In their 2001 book Real Options: A Practitioner's Guide, co-authors Tom Copeland and Vladimir Antikarov predicted that real options would supplant NPV in just 10 years. That prospect seems even more unlikely today. Still, if real options isn't poised to conquer the corporate world in the short run, perhaps it will prove its value in the long run.
"It took decades for NPV to become widely accepted in practice," points out Alexander J. Triantis, associate professor of finance at the University of Maryland's Robert H. Smith School of Business. "Real options is an even more sophisticated tool. It's going to take a few decades as well to be well integrated in corporations." Most companies have been using real options only since the mid-1990s, he notes. Eventually, "you won't have the special term 'real options,'" predicts Triantis. "It will just be called 'capital budgeting.'"
He may well be right — but in the long run, as Keynes said, we're all dead. The question is, how will real options fare in the near future?
It's Academic
In academe, at least, real options is enjoying a bull market. The notion that capital investments can be analyzed in terms of the options they contain — and that those options can be valued by the same tools used to price financial options — has earned chapters in standard finance textbooks, including Myers and Richard A. Brealey's Principles of Corporate Finance. Real options is now taught in most if not all MBA programs, and what's more, it's an interdisciplinary subject, found not just in finance but also in strategy and information-systems courses.
Meanwhile, real options has spawned a sizable academic literature. Professors have proposed the technique as an analytic hammer for practically every investment nail under the sun — from natural-resource investments and new products to start-ups, acquisitions, factories, information technology, and more.
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.
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