Real-Options Valuations: Taking out the Rocket Science. (Strategic Management)
Amram, Martha, Howe, Keith M., Strategic Finance
We clearly live in a world of financial extremes, and the pendulum has now swung back. Public accountants are signing off on corporate books with near paralyzing conservatism; financial analysts are screaming transparency" at the companies they follow; and the mantra of the day among the government and corporate leaders is "fix corporate goverance.
It might seem that the tense financial mood would make real options irrelevant and useless, but, in fact, interest in the valuation and strategy technique remains strong. Yet without some changes, managerial patience with the complexity of a typical real-options calculation may rapidly wear thin. Too often, real options seems to need rocket science. Managers appropriately ask, "Why should we learn differential calculus?"
In this column, we tackle the computational complexity by first demonstrating when and why the real-options approach may actually be the most straightforward and then laying out some simple guidelines to maintain transparency in real-options calculations.
Why Real Options?
The two most common options used in corporations are growth options and abandonment options. For both, the option value is determined by an opportunity to make a decision: "If things go well, then we'll make the next investment" or "if things go poorly, then we'll kill the project." The if-then statements reflect the contingent decision embedded in the real option.
Contingent decisions are present in nearly every growth opportunity. While there is a tendency to fall back on the "tried and true" valuation techniques such as payback, return on capital, and discounted cash flow, none of them can correctly value a growth opportunity. They all significantly undervalue the opportunity to make a decision in the future and thus lead to an investment strategy that is too conservative and too cautious. Today it may seem prudent to save dollars and stay lean, but very quickly the mandate from the financial markets will change to "show us growth!" The real-options framework is the correct valuation technique for growth opportunities when companies want to move beyond mere survival.
More Than the Number
If valuation were simply the process of producing a number, more companies would have adopted real options and a host of other innovative valuation techniques. In a recent book, Value Sweep, Martha Amram (a co-author of this column) argues that the social life of the number matters--our business/social community influences how the valuation result is shaped, transmitted, and used.1 A successful valuation result is more than a number; it helps to "connect the dots" for the different players who need to buy into or agree to the growth project.
Valuation of growth projects often fails to articulate the imbedded contingent decisions, leaving managers skeptical of the valuation results. Without alignment of the valuation framework and how managers think they're going to run their project, the valuation result lacks credibility. Further, when finance staff enter the discussion by forcing a complex growth project into a straitjacket of well-understood financial techniques--regardless if those techniques are appropriate for the project at hand--the valuation result is further distanced from credibility.
We argue for a two-fold change in perspective. First, recognize when and where real options should be used--when it is the appropriate tool. (See our column in the December 2002 issue for more detail.) Second, we propose five simple steps to remove the density of real-options calculations. Transparency is not an option in valuations; transparency is a mandate. Finance staff must make the analysis clear to the other functions. No one is willing to rely on rocket science.
Successful Real-Options Calculations
Table 1 shows some simple guidelines for getting real-options calculations focused. Before we walk through each, let's pause for a quick perspective. …