Academic journal article Research-Technology Management

Risk-Adjusted Valuation of R&D Projects: R&D Management Has Historically Been Very Much the Art of Creating Value by Managing an Extraordinary Degree of Risk. Here Is Another Step Forward in the Rapid Evolution of the Quantitative Tools Needed to Transform Your Practice from Art to Analytical Science

Academic journal article Research-Technology Management

Risk-Adjusted Valuation of R&D Projects: R&D Management Has Historically Been Very Much the Art of Creating Value by Managing an Extraordinary Degree of Risk. Here Is Another Step Forward in the Rapid Evolution of the Quantitative Tools Needed to Transform Your Practice from Art to Analytical Science

Article excerpt

Every industrial R&D project plan envisions a payoff. In financial terms, this payoff can be represented by the project's Net Present Value in the year it is commercialized (1). But the payoff is inevitably diminished by what might be called "The Three Horsemen of the R&D Apocalypse": 1) the time value of money; 2) the risk of technical failure; and 3) the cost of the R&D program itself. Given the value-destroying potential of these three factors, senior management will wish to determine whether its continuing investment in R&D is creating value, and if so, how much. A linear approach to this judgment is inevitably flawed, since it does not include the value of management's flexibility to respond to changes in the marketplace or in the technology outlook.

In this article, I present a unified approach to the valuation of an R&D project that integrates three analytical tools: Discounted Cash Flow, Decision Trees and Real Options (2). The value calculation is basic, once the input parameters have been established. By extension, the sum of the values of its individual projects defines a minimum value for the R&D portfolio. The method presented below is especially well suited to run in the context of a stage gate management system.

Why might this be important? The Discounted Cash Flow approach is well established and beloved of finance executives, but is known to systematically underestimate the value of R&D projects (and other intangible assets). The Decision Tree approach, sometimes labeled "Decision and Risk Analysis," captures the substantial value of the Option to Abandon. It quantifies unique risk and creates value by structuring R&D programs into a series of go/no-go decision points that exploit the option to abandon (3). This fact has been one reason for the widespread adoption of stage gate methodology, although the rationale has hitherto been largely qualitative (4).

The Real Options approach has generally been treated independently from Decision Trees. It captures value from the management of market risk, risk that cannot be diversified.

In reality, the two approaches are additive, compatible, and form a powerful combination. Technically, the Real Options method is more appropriate for valuation of R&D project plans than Discounted Cash Flow because plans are options, not assets (5).

This article describes how Decision Trees and Real Options can be combined into a single calculation (Decision Tree/Real Options), reducing valuation to two steps: Discounted Cash Flow followed by Decision Tree/ Real Options. After the Discounted Cash Flow step has been performed to obtain a best estimate of business plan value, Decision Tree/Real Options then captures full value from both unique and market risk. In effect, we create a compound option based on multiple options to abandon, which also incorporate the value of call options capturing market risk.

Who can benefit from this analytic approach? Broadly speaking, it fits situations with high risk, exposure to volatile markets, longer time horizons, and progressively increasing development costs. In addition to industrial R&D, venture capital, petroleum exploration and screenplay development fit the profile. The methods are particularly useful when a historical data base is available regarding the odds of project success, as in the pharmaceutical industry or in the development of new specialty chemicals. If the calculations are valid, those using them will invest in opportunities that competitors will pass up--a potentially enormous competitive advantage.

I. Setting Up the Calculation

Framing the problem

Although not the focus of this paper, it must be realized that the most important, and time-consuming, step in the valuation of technology is to understand the business situation and frame the option credibly (6). The successful practitioner must draw not only on his own expertise and industry experience, but on dialog with experts: R&D managers, marketing execs, economic evaluators, and licensing specialists. …

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