Real Options: New words for old ideas

In a previous newsletter I discussed value-adding, and said that there is “always the most potential for value-adding at the start of projects, when lots of alternatives are available.”  I could have said: “… when lots of options are available.” 

Options are good!  “More choice” is better than “less choice.”

Business is always subject to uncertainty, and when things don’t turn out the way you envisage you have greater capacity to adapt.  Stockpiles and inventories, for example, allow more choices.  These real options to change are worth something!

Good management has always understood this.  Now the theory is catching up to the practice.  (As they say: an economist is someone who sees something working in practice and wonders whether it will work in theory!). 

The economic term for these choices is: Real Options.  Financial options are options to buy and sell shares or some financial instrument at some time in the future.  Real options apply to actual choices in day-to-day decision-making.

Let’s say I own a processing plant and I have the opportunity to expand into some new production using some new technology.  There is lots of uncertainty—not just in the new technology, but also in the selling price of the product.  The range of possible returns to investment runs anywhere from –5% to 25% as shown in figure 1.

Figure 1

This investment opportunity doesn’t look too great.  There is a 35% chance that the return won’t even cover the cost of capital, and the 8.75% expected return doesn’t rate very favourably against other opportunities.  Too much risk and not enough return. 

Question: How highly would you value such an opportunity? 

Answer: Not much—for now, at least.  But it may be worth something in the future.

If the risk/return profile isn’t likely to change then the option to develop it in the future is worth very little.  But the operative word is “change.”  We have to dissect the uncertainty into its components—separating the elements that might change from the elements that won’t change.

Figure 2 shows the curve in figure 1 as the summation of two underlying components.

Figure 2

The curve on the left (Curve A) is the range of outcomes assuming the new technology is unsuccessful, whereas curve B is the range of outcomes assuming the technology is successful. 

Both of these curves still show lots of uncertainty due to product pricing—and this is outside our control.  We won’t be any more confident of this in the future than we are now, so an option to delay due to this cause is not worth anything.

But the same is not true about the technology uncertainty.  If we knew the technology was going to be successful we would have a viable project (curve B) and this is worth something.  But at this stage we reckon this is only a 50/50 chance.

Now we can start to value the option.  There are three conceptual steps:

Œ Assume the technology is successful at some time in the future, yielding curve B.  “Time” means: the time when we have to make a commitment.  Estimate when this is, and determine the risk/return profile.  What is the value of curve B, discounted to today?  Let’s say this is $20 million.

� What is the probability of curve B materializing … assessed with our current knowledge?  In this case: 50%.

Ž What cost (investment in new knowledge) is there to get from where we are now to the point where we can make this decision?  Let’s say this is $5 million.

Then the value of the option is:
 ($20 million x 0.5) ‑ $5 million = $5 million.

Now you wouldn’t necessarily pay this much for the option.  Paying $5 million for the option, plus another $5 million to prove up the technology, in return for a 50/50 chance of owning something worth $20 million is not good enough odds for business.  But any value up to $5 million will yield an expected profit.

Many projects have imbedded options that cost you nothing.  Most new investments offer scope for expansion, and the expansion, though not profitable today, frequently becomes a very profitable investment in the future.  In effect, today’s investment includes an imbedded option to expand.  Many assessments overlook the value of these imbedded options.  And in some cases the only thing of value is the option …. in the heady days of the technology boom the only value in some internet stocks was in the options that they gave rise to. 

The concept is very simple, but the application is a little more subtle.  There are some rules you should consider.

1  Options are worth more when there is greater uncertainty (and worth nothing when there is no uncertainty—why?).  It may be more efficient to eliminate the uncertainty.  Futures markets and forward sales do this in part.  Just-in-time systems eliminate stockpiles and inventories by relying on no uncertainty in parts arrival.

2  An option is only worth something if the uncertainty when you exercise the option will be less than the uncertainty now.  If sale prices, or exchange rates etc. will be just as unpredictable in the future as they are now, then options to delay are of little value.  But a technology that can be resolved between now and then does have option value.

3  Ideally, options should be proprietary.  A friend of mine wanted to hold an option (at some cost) on a property because freight rates were likely to decline and make his hitherto-uneconomic project viable.  If freight rates for his project alone were likely to decline, then this would have been a good strategy.  But if freight rates in general were likely to decline, then his competitors would also benefit, and the relative economics of his project would be little changed.  Be wary of the value of shared options!  With shared options your competitor may benefit from the delay/change even more than you do.

4  Unlike financial options that have little or no uncertainty as to when they are exercised, real options can usually be exercised at any time.  This represents additional uncertainty and reduces the value of the option.  You risk exercising a real option (e.g. starting a delayed project) when you really shouldn’t, or not exercising when you really should!

5  The value of options increases with increasing uncertainty, but not the value of the underlying investment!  If you are in the business of developing and trading options, then by all means, wish for more uncertainty.  But if you are running a real, capital intensive business, then wish for less uncertainty!

And now a quiz:  “Procrastination” is supposed to be bad from a management perspective.  Under what conditions is procrastination entirely rational?