When executives create strategy, they project themselves and their organization into the future, creating a path from where they are now to where they want to be some years down the road. In competitive markets, though, no one expects to formulate a detailed long-term plan and follow it mindlessly. Unfortunately, the financial tool most widely relied on to estimate the value of strategy—discounted-cash-flow DCF valuation—assumes that we will follow a predetermined plan, regardless of how events unfold.
A better approach to valuation would incorporate both the uncertainty inherent in business and the active decision making required for a strategy to succeed. It would help executives think strategically on their feet by capturing the value of doing just that—of managing actively rather than passively.
Options can deliver that extra insight. Advances in both computing power and our understanding of option pricing over the last 20 years make it feasible now to begin analyzing business strategies as chains of real options.
As a result, the creative activity of strategy formulation can be informed by valuation analyses sooner rather than later. In financial terms, a business strategy is much more like a series of options than a series of static cash flows. Executing a strategy almost always involves making a sequence of major decisions.
Some actions are taken immediately, while others are deliberately deferred, so managers can optimize as circumstances evolve.
The strategy sets the framework within which future decisions will be made, but at the same time it leaves room for learning from ongoing developments and for discretion to act based on what is learned. In financial terms, a business strategy is much more like a series of options than it is like a series of static cash flows. That article explains how to get from conventional DCF value to option value for a typical project—in other words, it is about how to get a number.
This article extends that framework, exploring how option pricing can be used to improve decision making about the sequence and timing of a portfolio of strategic investments.
Managing a portfolio of strategic options is like growing a garden of tomatoes in an unpredictable climate. Walk into the garden on a given day in August, and you will find that some tomatoes are ripe and perfect. Any gardener would know to pick and eat those immediately.
Other tomatoes are rotten; no gardener would ever bother to pick them. These cases at the extremes—now and never—are easy decisions for the gardener to make. In between are tomatoes with varying prospects. Some are edible and could be picked now but would benefit from more time on the vine.
The experienced gardener picks them early only if squirrels or other competitors are likely to get them. However, they are sufficiently far along, and there is enough time left in the season, that many will ripen unharmed and eventually be picked. Still others look less promising and may not ripen before the season ends. But with more sun or water, fewer weeds, or just good luck, even some of these tomatoes may make it.
Finally, there are small green tomatoes and late blossoms that have little likelihood of growing and ripening before the season ends. There is no value in picking them, and they might just as well be left on the vine. Most experienced gardeners are able to classify the tomatoes in their gardens at any given time.
Beyond that, however, good gardeners also understand how the garden changes over time. By the last day, all of it falls into one or the other because time has run out.
The interesting question is, What can the gardener do during the season, while things are changing week to week? A purely passive gardener visits the garden on the last day of the season, picks the ripe tomatoes, and goes home. The weekend gardener visits frequently and picks ripe fruit before it rots or the squirrels get it. Active gardeners do much more. Not only do they watch the garden but, based on what they see, they also cultivate it: Of course, the weather is always a question, and not all the tomatoes will make it.
They are monitoring the options and looking for ways to influence the underlying variables that determine option value and, ultimately, outcomes. Option pricing can help us become more effective, active gardeners in several ways. Finally, it can suggest what to do to help those in-between tomatoes ripen before the season ends.
Option space is defined by two option-value metrics, each of which captures a different part of the value associated with being able to defer an investment. Option space can help address the issues an active gardener will care about: We called that metric NPV q and defined it as the value of the underlying assets we intend to build or acquire divided by the present value of the expenditure required to build or buy them.
Put simply, this is a ratio of value to cost. When the value-to-cost metric is between zero and one, we have a project worth less than it costs; when the metric is greater than one, the project is worth more than the present value of what it costs.
It measures how much things can change before an investment decision must finally be made. That depends both on how uncertain, or risky, the future value of the assets in question is and on how long we can defer a decision.
In the previous article, this second metric was called cumulative volatility. Option space is defined by these two metrics, with value-to-cost on the horizontal axis and volatility on the vertical axis.
Within the interior of the rectangle, option value increases as the value of either metric increases; that is, from any point in the space, if you move down, to the right, or in both directions simultaneously, option value rises. How does option space help us with strategy? A business strategy is a series of related options: That obviously makes things more complicated.
To do that, we need to explore the option space further. In a real garden, good, bad, and in-between tomatoes can turn up anywhere.
Not so in option space, where there are six separate regions, each of which contains a distinct type of option and a corresponding managerial prescription. We carve up the space into distinct regions by using what we know about the value-to-cost and volatility metrics, along with conventional NPV.
Traditional corporate finance gives us one metric—NPV—for evaluating projects, and only two possible actions: In option space, we have NPV, two extra metrics, and six possible actions that reflect not only where a project is now but also the likelihood of it ending up somewhere better in the future.
When we return to assessing strategies, this forward looking judgment will be especially useful. At the very top of our option space, the volatility metric is zero. With business projects, the latter is far more likely. If the value-to-cost metric is greater than one, we go ahead and invest now. Region 1 contains the perfectly ripe tomatoes; it is the invest now region. Region 6 contains the rotten ones; the prescription there is invest never. What about projects whose value-to-cost metric is greater than one but whose time has not yet run out?
All such projects fall somewhere in the right half of our option space but below the top. Projects here are very promising because the underlying assets are worth more than the present value of the required investment. Does that mean we should go ahead and invest right away? We want to be able to distinguish between those cases.
The key to doing so is not option pricing but conventional NPV. In terms of the tomato analogy, we are looking at a lot of promising tomatoes, none of which is perfectly ripe. Even so, they are very promising because their value-to-cost metric is positive and time has not yet run out. I call this region probably later because, even though we should not invest yet, we expect to invest eventually for a relatively high fraction of these projects. In the meantime, they should be cultivated.
These options are in the money. They are like tomatoes that even though not perfectly ripe are nevertheless edible. We should be considering whether to pick them early. If there is value associated with deferring, why would we ever do otherwise? Sometimes, especially with real options, value may be lost as well as gained by deferring, and the proper decision depends on which effect dominates.
The financial analog to such a real option is a call option on a share of stock. If the stock pays a large dividend, the shareholder receives value that the option holder does not. The option holder may wish to become a shareholder simply to participate in the dividend, which otherwise would be forgone.
Think of the dividend as value lost by deferring the exercise decision. In the case of real options, where the underlying asset is some set of business cash flows, any predictable loss of value associated with deferring the investment is like the dividend in our stock example. Phenomena like pending changes in regulations, a predictable loss of market share, or preemption by a competitor are all costs associated with investing later rather than sooner and might cause us to exercise an option early.
Or, to use the tomato analogy, we might pick an edible tomato early if we can predict that squirrels will get it otherwise. Unpredictable gains and losses, however, would not lead us to exercise our options early. Immediate investment will not always be the optimal course of action because by investing early the company loses the advantages of deferring, which also are real.
Deciding whether to invest early requires a case-by-case comparison of the value of investing immediately with the value of waiting a bit longer—that is, of continuing to hold the project as an option.
I refer to that part of the option space as maybe now because we might decide to invest right away. All options that fall in the left half of the space are less promising because the value-to-cost metric is everywhere less than one, and conventional NPV is everywhere less than zero.
But even here we can separate the more valuable from the less valuable. The upper left is unpromising territory because both the value-to-cost and volatility metrics are low.
These are the late blossoms and the small green tomatoes that are unlikely to ripen before the season ends. I call this part of the option space probably never, and we can label it region 5. In contrast, the lower section of this left half of the space has better prospects because at least one of the two metrics is reasonably high.
I call it maybe later, and we can label it region 4. As an example of what we learn from the tomato garden, consider six hypothetical projects that are entirely unrelated to one another.More...