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Why companies have been slow to adopt the valuation technique.
Edward Teach, CFO Magazine
July 1, 2003
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?
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.
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.
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.
Information technology is another fertile, cross-industry field for applying real options. IT now consumes the greater part of corporate capital budgets, and large applications are notoriously risky. But their deployment can be optimized, and the risk minimized, through real-options analysis, according to Mark Jeffery, assistant professor of technology at Northwestern University's Kellogg School of Management. In a recent paper, Jeffery and co-authors Sandeep Shah and Robert J. Sweeney demonstrated how real-option analysis can determine the optimal rollout of an enterprise data warehouse, via the phase-wise consolidation of data marts.
What's more, Jeffery argues that real options can better optimize a portfolio of IT investments. The classical application of real options, and the point of much research, is to show that a given investment with a negative NPV may in fact have substantial value, thanks to its embedded options. But in today's capital-rationed environment, all IT investments are presumed to have a positive NPV, and a substantial one at that. Jeffery therefore advocates calculating the real-options value of positive-NPV projects, to arrive at an "expanded" NPV for each — and an optimal ranking of IT investments.
The trouble is, although there is widespread interest in taking a portfolio approach to managing IT investments, few companies — 24 percent — actually optimize such portfolios, according to a recent survey of 130 senior IT executives conducted by the Kellogg School, DiamondCluster International, and the Society for Information Management. None of the executives surveyed used real options.
In the end, it will take more than research papers and case studies to persuade companies to adopt real options. Numerous objections must be overcome; here are four big ones.
Real options is a "black box." The sophisticated mathematics (such as partial differential equations) of real options, and the consequent lack of transparency and simplicity, are real concerns. But thanks to more-powerful PCs and spreadsheets, one can model multiple options with little more than a knowledge of high school algebra and binomial lattices, say experts. Jeffery, who has a PhD in theoretical physics, and his research assistant and co-author Shah are devising "little Excel macros that do the binomial model, so you can calculate compound options in a very straightforward way," he says. Meanwhile, software publishers like Decisioneering now offer off-the-shelf applications for modeling complex real-options scenarios.
"We've missed something really important," comments Martha Amram, chief economist at PLX Systems, a Pasadena, California-based software company, and a prominent real-options author. "To communicate, [real-options analysis] has to be transparent and clear."
Real options is a new economy tool. It doesn't help the cause that Enron was considered an innovative user of real options. Some observers maintain, however, that the reputation was deserved, and that use of the tool had little to do with Enron's financial difficulties or downfall. Meanwhile, loose talk about growth options may have helped fuel the astronomical valuations of some Internet companies before the market bubble burst. Then again, rigorous application of real options might have told a different story. A few years ago, when Amazon.com's stock was selling for $76 or so, an analysis using real-options theory by UCLA professor Eduardo S. Schwartz pegged its worth at around $12 — a more realistic value, as it turned out.
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.